Just the Beginning ... The Derivatives Trap

Earthside Comments: This BIG Bush Bailout Plan is not just about bad mortgages ... it is about mortgage related derivatives.

Below are several articles that explain what this means. We're talking about just huge, tremendously large amounts of money -- up to a QUADRILLION dollars!

Here is what is key: banks don't have to completely fail for the cost of derivatives to kick in, as they do worse or become unstable, they have to come up with more collateral to cover their derivative contracts. Since these financial devices are unregulated, who knows how many billions of dollars this may amount to. (Read about this in the Paul Solomon/PBS article second from the bottom of this post.)

So, Bush and Paulson and the CEOs and majority stockholders in the investment banks need money to keep afloat to cover their derivative obligations. Since they are also holding these non-performing mortgage loan bundles, they are basically busted. So, it is not that they are in trouble just because of subprime mortgages, but because they made very expensive bets that they are losing.

Then read the very last analysis in this post ... and you'll see just how much trouble these banks are in and how the BIG Bush Bailout Plan is far from any solution to this crisis.

We need to communicate to our Congressional representatives that this bailout is a terrible idea. We maybe in for a deep recession no matter what and federal spending to "prime the pump" maybe imperative for stimulating the economy -- that cannot be done if two or three trillion dollars is tacked onto the debt just to get Wall Street sharp dealers off the hook.

Link: Ben Stein almost lets out the Big Secret | Inky99/Daily Kos

Ben Stein, a man whose character and politics I find to be despicable, has a column today that I noticed on Yahoo Finance. A good buddy of mine, who stays closely abreast of these kinds of financial shenanigans, told me the other day that Ben Stein, in spite of his character flaws, had some really astute observations on this whole mess. So out of curiosity today, I clicked on the link.

And I have to admit, I am astounded by what he said. And even more by what he didn't say. The Big Question he leaves unanswered. It's seriously mind-blowing.

Here is the article:

Everything You Wanted to Know About the Credit Crisis But Were Afraid to Ask

And here is the meat of his article, which leads to the huge gaping hole which he leaves unfilled:

The crisis occurred (to greatly oversimplify) because the financial system allowed entities to place bets on whether or not those mortgages would ever be paid. You didn't have to own a mortgage to make the bets. These bets, called Credit Default Swaps, are complex. But in a nutshell, they allow someone to profit immensely - staggeringly - if large numbers of subprime mortgages are not paid off and go into default.

The profit can be wildly out of proportion to the real amount of defaults, because speculators can push down the price of instruments tied to the subprime mortgages far beyond what the real rates of loss have been. As I said, the profits here can be beyond imagining. (In fact, they can be so large that one might well wonder if the whole subprime fiasco was not set up just to allow speculators to profit wildly on its collapse...)

These Credit Default Swaps have been written (as insurance is written) as private contracts. There is nil government regulation of them. Who writes these policies? Banks. Investment banks. Insurance companies. They now owe the buyers of these Credit Default Swaps on junk mortgage debt trillions of dollars. It is this liability that is the bottomless pit of liability for the financial institutions of America.

Did you see that bolded section?

In fact, they can be so large that one might well wonder if the whole subprime fiasco was not set up just to allow speculators to profit wildly on its collapse...

Many of us have already said that, including a LOT of prominent economists like Michael Hudson. These people knew the loans they were making were bad loans. They knew the money wouldn't be paid back. Which has always bothered me -- why did they make bad loans on purpose? For short term gain? Well, yes, at least as far as some of the people involved go, like mortage agents in banks who worked on commission. But the people in charge were letting them make these loans. Why?

Now that is what leads to the real meat of what he's saying, the "Elephant in the Room", That Which Shall Remain Unspoken:

They now owe the buyers of these Credit Default Swaps on junk mortgage debt trillions of dollars. It is this liability that is the bottomless pit of liability for the financial institutions of America.

Somebody, somewhere, is blackmailing the economy. Because somebody, somewhere, is owed these TRILLIONS of dollars. And it is THEY who are holding a gun to the economy and demanding payment, and all of Wall Street, and even the Fed, cannot pay this debt.

So WHO is this Tony Soprano-like world figure? Who are these people? Why are we not identifying them, and talking to them, and negotiating with THEM, whoever they are, to keep from bankrupting the American economy in their favor?

Somebody, somewhere, is blackmailing the entire United States economy. Somebody, somewhere, has a gun to our head. And to the head of the American government.

I want to know who they are. I want them identified.

Who are they? And why are we willing to bankrupt the entire country in order to pay them off?

Somebody, somewhere, has way more power than they should have. Who?

Link: The Next Accident | Robert Peston/BBC NEWS

New York State wants to bring law and order to the last wild frontier of global finance, the credit default swaps market.

It's yet another attempt to close a stable door after a galloping herd has not only bolted but has already crossed the state line.

Credit default swaps are - in essence - contracts to insure debt, especially debt in the form of bonds, against the risk of default.

They began life as a sensible initiative by banks to reduce the risks they were running in lending to companies. Banks used them to lay off the risks of default to specialist insurers and other financial firms.

But as with all good things in global finance, especially the unregulated things, the market then binged on these credit derivatives.

Their use exploded with the boom in collateralised debt obligations made out of subprime loans, because the vendors of these toxic securities took out credit-default-swap contracts to secure cherished AAA ratings - or to turn poo into gold (most of it's since turned back into poo, occasioning great pain for the banking system).

And, in the corporate markets, credit default swaps became an instrument of pure speculation. If hedge funds wanted to speculate on the fortune of a big business, they would often buy and sell these credit derivatives as an alternative to shares.

Why?

Well this was - for a while at least - a huge, liquid and unregulated market, a true Wild West, almost free from the nosey attention of sheriffs and regulators who take an annoying interest in what goes on in stock markets.

Anyway the notional value of extant credit derivatives, in terms of the underlying value of the debt insured, was something over $60,000bn [$60 trillion] at the end of 2007, or more than five times the value of the entire US economy.

However many analysts say the better measure of the size of market is the $2,000bn [$2 trillion] fair value of outstanding contracts - because that's an attempt to assess potential losses and gains.

Both numbers are big, even if one of those falls into the too-big-to-fathom category.

Perhaps the more important point is that over just the past three years, the size of the market has increased by 15 times.

Which simply tells you that a lot of stupid contracts have been written at the wrong price, since in the two years to August last year most bankers and financial firms were pricing financial risk as though it were a myth from a bygone age.

Anyway it was AIG's exposure to credit derivative contracts that did it in just a few days ago: one of its subsidiaries had to find a colossal amount of cash in a hurry under its credit derivative contracts, because of a contractual requirement to post collateral after its credit-worthiness was marked down by rating agencies.

All of which is to explain why the New York Governor David Paterson issued a statement yesterday saying that his state will regard as insurance, in a formal sense, those contracts sold to investors who own bonds they want to protect from default.

It will therefore require proof from the entities selling the insurance that they have the resources to actually pay possible claims under the relevant contracts.

Doh!

I'd laugh if I didn't want to cry.

Paterson is implying that many of the writers of credit default swaps don't have the means to make good on their liabilities, that they were taking a punt, hoping to make easy money from insurance they thought would never be claimed on.

It's one of those "emperor's new clothes moments" that leaves me almost lost for words (almost).

To state the bloomin' obvious (as is my wont), we should be worried about this because we are entering a pronounced economic slowdown in which many companies will have difficulties servicing their debt.

And so we will start to see a raft of claims under credit derivative contracts, to add to those already triggered by the collapses of Lehman, Fannie and Freddie.

If the insurers can't pay, well that could lead to losses and pain all over the place, for hedge funds, for pension funds and for banks - which may still be living in the fools' paradise of thinking that their balance sheets are stronger than they are, thanks to all that lovely insurance they've taken out.

Link: The Lurking Danger of Derivatives – Wall Street’s House of Cards | Alpha-Zone

Many Americans and lawmakers are worried about the exposure large corporations have to subprime mortgages and mortgage securities. This problem is dwarfed by their exposure to derivatives. The value of these derivatives can be more than the assets of the company.

Over 90 percent of derivatives are traded outside of the regulated exchanges. Most companies keep their holdings off the balance sheet or may include their holdings in the footnotes of their financial statements. As a result, most investors are unaware of the risk. Even if a brokerage firm is not private, it may be difficult to pull the numbers.

According to Martin D Weiss with Money and Markets, nearly 97 percent of the U.S. bank-held derivatives are concentrated in the hands of just five major U.S. banks. These banks are JPMorgan Chase, Citibank, Bank of America, Wachovia and HSBC.

What are Derivatives?

Derivatives are one of the more complicate financial instruments but can be used to hedge risk. They include futures, forwards, options, and swaps. They can be based on all sorts of assets including stocks, bonds interest rates, exchange rates or even weather. Warren Buffet called them “financial weapons of mass destruction”.

What can Go Wrong?

Weiss created a scenario to help explain the disaster that can be caused by derivatives:

Let’s say you are a senior derivatives trader for a big firm like Morgan Stanley (which has $7.1 trillion in derivatives on its books and about $10 billion in capital). You could be responsible for $500 billion in derivatives contracts with Bank A, essentially betting that interest rates will decline.

But you get worried and decide to hedge yourself by placing a similar bet with Bank B that interest rates will go up. This protects you right? Either way, you can’t lose.

But you can lose, and you can lose big. In our scenario the rates might go up. You lose with bank A but win with bank B. Normally you could take the winnings from B and pay A. But what if Bank B defaults because of large mortgage losses? Now you are in trouble and have to liquidate your company’s capital to pay off Bank A. Now your company is at risk for default and the whole financial network can fall like a house of cards.

Who is at risk?

Besides some of the largest banks as we pointed out above, Merrill Lynch has $4.2 trillion. Morgan Stanley has $7.1 trillion. Weiss believes Lehman Brothers has significantly less at $729 billion. But if each entity begins to default, nearly every investor and or mutual fund is at risk.

Link: Could you explain what a derivative is and how this is part of the Wall Street problem? | Paul Solman/PBS

Question/Comment: On the NewsHour tonight, the speaker stated that some the problem with the fall of Wall Street is related to use of derivatives and lack of regulation of this. Could you explain further what a derivative is and how this is part of the problem?

Paul Solman: As law professor Frank Partnoy explained in a story we did a few years ago: "Derivatives are financial instruments whose value is linked to something else. They're basically fancy instruments that have evolved over the last ten years that enable investors and institutions to bet on virtually anything, from interest rates or exchange rates to commodities."

Our NewsHour story explains the derivation of derivatives, and I suggest you watch and/or read it. But what's important today is that a multi-trillion dollar market in these bets has mushroomed without any real regulation, in part because in 2000, in the words of one account, hours before Congress was to leave for Christmas recess, Senator Phil Gramm slipped a 262-page amendment into the appropriations bill forbidding federal agencies to regulate the financial derivatives industry.

Forbidding indeed.

Now in point of fact, rather innocent bets like futures or options are also derivatives, but what the speaker meant was a TYPE of derivative known as a credit default swap. Very simple, really. It's a bet on whether some entity - a company, a government agency - is going to default on its credit and go bankrupt.

An example: Someone who loaned money to Lehman Brothers (by buying their bonds) might bet on Lehman going belly-up. Why? To protect their bonds. Lehman fails; they lose on the bonds, but cash in on the bet. It's a form of insurance. The price they pay for the "credit default swap" is, in essence, the insurance premium.

Why would someone else take the other side of the bet? WRITE the insurance, that is? Because it looked like easy money. How likely was it that Lehman Brothers would go bankrupt, a firm that had been in business, more or less, since 1844? Wouldn't YOU have given someone 100-1 (assuming you like to bet)?

But now, with so many firms going bankrupt, such bets have turned out to be killers. Literally, it would seem. AIG is mainly an insurance company. So maybe it shouldn't come as a surprise that it wrote lots of credit default swaps. Indeed, it even borrowed money to do so. But when the people with whom it bet - its so-called "counter-parties" - appeared ready to cash their bets, the lenders to AIG said, in effect: "Time for you at AIG to put up more collateral on your loans, because those bets of yours are looking shaky."

But how was AIG going to raise more collateral? By selling off assets going down in value? That would simply drive them down more, lowering the value of AIG's collateral, meaning they'd have to come up with even more collateral. A classic vicious circle, downward spiral, negative feedback loop - call it what you will.

Meanwhile, if AIG was in trouble with its lenders, its credit rating would drop, thus forcing AIG to put up even MORE collateral. More negative feedback. Down, down and down.

All kicked off in part because AIG went heavily into the credit insurance business, using derivatives known as credit default swaps.

Link: Analyst Whitney Sees Little Hope From Bailout | Reuters

The credit crisis that began last summer has intensified so much that any U.S. government bailout plan has "little hope" of improving core fundamentals over the near and medium term, said analyst Meredith Whitney.

The Oppenheimer & Co analyst cut her outlook for U.S. banks and forecast further dividend cuts and capital raises at banks. She projected a quarterly loss for Citigroup Inc.

"Since the onset of the credit crisis, over $2 trillion less liquidity has flown through the U.S. domestic capital markets than during...a year prior," Whitney said.

"With that much less available capital, both consumers and corporations have and will spend less," she added.

As the consumer comes under more pressure in the difficult economy, credit card debt may grow, Whitney wrote in a note to clients.

Whitney, however, noted that tighter credit standards and credit line reductions have already strained more consumers into defaulting across the spectrum of lending products.

"Credit market disruption has had underappreciated consequences on the economy... what started last summer has accelerated and intensified so much so that we believe any government bailout plan has little hope of improving core fundamentals over the near and medium term," Whitney said. ...

... Oppenheimer's Whitney expects the country's GDP to take a hit from likely moves by state governments to cut costs.

Given that over 12 percent of the U.S. GDP is driven by state and local government spending, and with many key states' 2009 budgets being under-funded, governments will be forced to cut costs and this will weigh significantly on GDP, she said.

Whitney said home prices were not close to bottoming and expects prices to ultimately be at least 25 percent lower from current levels. She also sees further declines in homeownership rate.

The unemployment rate, which is up over 40 percent year-on-year in key states, is "headed materially higher," Whitney said.

Analyst Whitney forecast a third-quarter loss of 36 cents a share for Citigroup. She had a prior profit view of 8 cents a share. She widened her fiscal 2008 loss estimate for Citigroup to $2.30 a share from $1.43 a share.

Whitney widened her third-quarter loss forecast for Wachovia Corp to 31 cents a share from 15 cents, and for fiscal 2008 to a loss of $5.18 a share from $5.

She cut third-quarter earnings estimates for Bank of America Corp to 40 cents a share from 75 cents, for JPMorgan Chase & Co to 21 cents a share from 40 cents a share, and for Wells Fargo & Co to 13 cents a share from 17 cents.

For fiscal 2008, Whitney cuts earnings estimates for Bank of America to $1.85 a share from $2.48, for JPMorgan to $1.65 a share from $1.95, and for Wells Fargo to $1.37 a share from $1.41.

Shares of Citigroup were down more than 1 percent at $19.78 in morning trade Tuesday on the New York Stock Exchange, while those of Wachovia were down 3 cents at $14.78.

Bank of America shares were up about 2 percent at $34.80, while shares of JPMorgan were up more than 1 percent at $41.41 and Wells Fargo's up more than 3 percent at $36.36.