Friday, December 2, 2011

Financial weapons of mass destruction strike again: naked

On October 23, 2008, in the middle of the biggest financial crisis since the Great Depression, Reuters ran an article entitled: “Greenspan says was ‘partially’ wrong on CDS regulation.”

“Former Federal Reserve Chairman Alan Greenspan acknowledged he was "partially" wrong in his belief that some trading instruments, specifically credit default swaps, did not need regulation.
Henry Waxman, the Democrat who chairs the U.S. House of Representatives Committee on Oversight and Government Reform, cited a series of public statements by Greenspan saying the market could handle regulation of derivatives without government intervention.
"My question is simple: Were you wrong?" Waxman said.
Greenspan said he was "partially" wrong in the case of credit default swaps, complex trading instruments meant to act as insurance for bond buyers against default.
"I made a mistake in presuming that the self-interest of organizations, specifically banks and others, was such that they were best capable of protecting their own shareholders and the equity," Greenspan said.
When asked by Waxman if his ideology pushed him to make bad decisions, Greenspan said he found a "flaw" in his governing ideology that has led him to reexamine his thinking” (Dixon 2008).

CDS is an acronym for Credit Default Swap, a credit derivative that resembles insurance in that the buyer pays a premium to the seller in order to protect against the default of another entity. The purchaser of a CDS may have an insurable interest in the entity on which CDS’s are being written, by being a creditor or a bondholder, for example, which consequently means that a legitimate interest in protection against default exists, and the purchase of CDS’s can be seen as constituting a hedge, or a way of managing risk. In case the purchaser does not have an insurable interest, however, the purchase of a CDS is termed “naked” and constitutes nothing more than speculation that the entity on which the CDS is written will default. In case of default or a credit event the seller of the CDS has to pay the CDS holder the previously agreed upon sum, as stipulated in the contract. So while this may seem to be a fairly straight-forward insurance-type product, the fact that these instruments are traded OTC, or “over the counter,” however, means that no one really knows who has written how many CDS’s, on whom, for how much, to whom they have been sold, or whether there is any money to pay out in case of a default. This last point came into focus quite clearly when American International Group (AIG) had to be bailed out by the US taxpayer to the tune of over $180 billion in large part because they did not have any money to pay out on the Credit Default Swaps they had written (Sjostrom Jr. 2008).  

As reported by the BBC, back in 2003, when the notional amount of the entire derivatives market was only $85 trillion, Warren Buffet famously likened them to time bombs and “financial weapons of mass destruction,” some of which seemed to have been devised by “madmen,” and the whole derivatives industry was similar to “hell... easy to enter and almost impossible to exit” (BBC 2003). While Buffet did not specify CDS’s at the time, by September 2011, when, as reported by The Bank of International Settlements (BIS 2011), the entire derivatives market had swollen to over $700 trillion and the notional amount of Credit Default Swaps outstanding was still $32 trillion, down from $62 trillion in 2007, the Financial Times had no problem running an article titled:”CDS: modern day weapons of mass destruction.” The article by Chapman (2011) cited a paper by Calice, Chen and Williams (2011) which found that “for several countries including Greece, Portugal and Ireland the liquidity of the sovereign CDS market has a substantial infuence on sovereign debt spreads,” meaning that CDS’s could contribute to rising bond yields and thus push up borrowing costs and increase the risk of default by sovereign countries. Faced with contagion in the Eurozone and a possible cascade of defaults, the German government, on whose shoulders much of the cost of bailing out the periphery falls, demanded a ban on “naked short selling” and, especially, “naked” CDS’s as well (Baker and Peel 2011).

In an article calling for a ban on “naked” CDS’s Wolfgang Münchau (2010) noted that a “naked a purely speculative gamble [without even] one social or economic benefit [which is something that] even hardened speculators agree on. [Moreover a] universally accepted aspect of insurance regulation is that you can only insure what you actually own [and not] even the most libertarian extremist would accept that you could take out insurance on your neighbour’s house or the life of your boss,” especially if you proceeded to light a match to the house or push the boss of a cliff, which, after keeping in mind the findings from above, is what the whole thing amounts to. Greece, Portugal, Ireland, Spain, Italy are all facing ruinous borrowing costs in late 2011 and it is utterly uncertain whether the Eurozone will make it through 2012.

Credit Default Swaps are consequently living up to the moniker given derivatives by Warren Buffett: “financial weapons of mass destruction.” Alan Greenspan, Robert Rubin and Larry Summers refused to consider regulation of CDS’s back in 1997 when Brooksley Born testified before Congress that trading in unregulated derivatives would "threaten our regulated markets or, indeed, our economy without any federal agency knowing about it" (van den Heuvel 2008). They refused, due to the belief noted above that the self-interest of rational economic agents and organizations would be sufficient to prevent the taking on of too much risk and “was such that they were best capable of protecting their own shareholders and the equity.” After admitting that this belief was wrong and that he had found a flaw in his worldview, his ideology, the disciple of Ayn Rand also admitted that: “This modern risk-management paradigm held sway for decades. The whole intellectual edifice, however, collapsed in the summer of last year” (Andrews 2008). We are still dealing with the fallout and should prepare for worse, as reported by zerohedge, who address the meaning and significance of the derivatives market number reported by the BIS being

the biggest ever reported in the financial world: the number in question is $707,568,901,000,000 and represents the latest total amount of all notional Over The Counter (read unregulated) outstanding derivatives...Indicatively, global GDP is about $63 trillion if one can trust any numbers released by modern governments...

for the six month period ended June 30, 2011, the total number of outstanding derivatives surged past the previous all time high of $673 trillion from June 2008, and is now firmly in 7-handle territory: the synthetic credit bubble has now been blown to a new all time high. Another way of looking at the data is that one of the key contributors to global growth and prosperity in the past 10 years was an increase in total derivatives from just under $100 trillion to $708 trillion in exactly one decade. And soon we have to pay the mean reversion price. 

What is probably just as disturbing is that in the first 6 months of 2011, the total outstanding notional of all derivatives rose from $601 trillion at December 31, 2010 to $708 trillion at June 30, 2011. A $107 trillion increase in notional in half a year. 

There is much more than can be said on this topic, and has to be said, because an increase of that magnitude is simply impossible to perceive without alarm bells going off everywhere, especially when one considers the pervasive deleveraging occurring at every sector but the government. All else equal, this move may well explain the massive surge in bank profitability in the first half of the year. It also means that with banks suffering massive losses, and rumors of bank runs and collateral calls, not to mention the aftermath of the MF Global insolvency, the world financial syndicate will have no choice but to increase gross notional even more, even as the market value continues to get ever lower, thus sparking the risk of the mother of all margin calls: a veritable credit fission reaction.
But no matter what: the important thing to remember is that "they are all hedged" - or so they say, a claim we made a completely mockery of a few weeks back. So ex-sarcasm, the now parabolic increase in derivatives means that when the bilateral netting chain is once again broken, and it will be (because AIG was not a one off event), there will simply be trillions more in derivatives that no longer generate a booked cash flow stream for the remaining counterparty, until at the very end, the whole inverted credit0money pyramid collapses in on itself. 

Because once the whole bilateral netting chain is broken, net becomes gross. And gross market value becomes total notional outstanding. And, to quote Hudson, it's game over. 

Expect to see gross market value declines persisting even as the now parabolic increase in total notional persists. At this rate we would not be surprised to see one quadrillion in OTC derivatives by the middle of next year.
And, once again for those confused, the fact that notional had to increase so epically as market value tumbled most likely means that the global derivative pyramid scheme (no pun intended) is almost over.


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