Financial Weapons of Mass Destruction: A Perspective

“The US government’s debts have ballooned so badly the National Debt Clock in New York has run out of digits to record the spiralling figure.  The digital counter marks the national debt level, but when that passed the $10 trillion point last month, the sign could not display the full
amount.”

There has been a lot of dialogue around the risks associated with derivatives in the financial system.  Bill Gross coined the term the Shadow Banking System, Warren Buffett warned of Financial Weapons of Mass Destruction, Bear Stearns unwound and was not allowed to fail in part due to its 13 trillion dollar counter-party exposure.  With the Bear Stearns experience behind us, government officials felt that letting Lehman fail would not pose systemic risk to the system.  As a precaution though, ISDA opened a special trading session for two hours on September 14th, a Sunday.  The 2-4pm trading session that day was set up for counter-parties on both sides of Lehman trades to cross or close out transactions in the event of a bankruptcy filing by that evening at 11:59PM.

Much blame has been placed on sub-prime mortgages, and more sadly some conservatives have lashed out at democrats and the CRA to finger point federally mandated lending to low and moderate income families as the source of all of our woes.  This practice, I must admit is less that bad politics, its simple ignorance and idiocy.  Predatory lending was not part of the CRA mandate, and it is despicable, but did not on its own bring down the system.

What we have been seeing over the last few weeks is a crisis of confidence.  The confidence that you and I have lost, is second to what started this panic.  The confidence lost by the American people was initially much less significant than the confidence institutions lost in each other.  It was the crisis of confidence in overnight lending, between banks and between banks and the Treasury, prior to the bailout, that got us to whisper about withdrawing cash from our savings accounts and stuffing it under our mattresses.

Today Barry Ritholtz posted a note and a reference to a Financial Times article about the $400 Billion Lehman CDS Unwind.  He also made a nice reference to a NYT assault on Greenspan who knew about the growing shadow banking system, but chose to leave it unregulated, defending his decision by saying that the marketability of risk ensures that those willing to take it do, and those unwilling do not.

With amazing vision and great clarity, on May 24th 2004, Martin D. Weiss, Ph.D., published a note in which he said:

Another problem about derivatives is that they can exacerbate trouble that a corporation has run into for completely unrelated reasons. This pile-on effect occurs because many derivatives contracts require that a company suffering a credit downgrade immediately supply collateral to counter-parties. Imagine then that a company is downgraded because of general adversity and that its derivatives instantly kick in with their requirement, imposing an unexpected and enormous demand for cash collateral on the company.  The need to meet this demand can then throw the company into a liquidity crisis that may, in some cases, trigger still more downgrades. It all becomes a spiral that can lead to a corporate meltdown.

Think back to 2007 when this great unwind started.  It began with the initial downgrades of lenders, banks, CDOs, and eventually the bond insurers by the rating agencies.  The rating agencies are also to blame, but too often singled out as sole culprits.  A large piece of this blame, besides a lack of regulation, does fall on the insurers, who were able and willing to insure just about anything packaged into a blue box with a white ribbon by the Tiffany’s of investment banks.

Ironically, despite the poor underwriting of the consumer loans that were made, the poor underwriting of credit insurance that was done at hefty profits, and the poor work by rating agencies, it is more than likely that the unregulated shadow banking (a.k.a. shadow insurance market) is what has led to institutional panic in recent weeks.

The comfort afforded by derivatives, which have been used mostly to insure debt, were a mechanism by which quant-types and physicists at “bulging bracket” investment banks could model products with attractive returns and “minimal” risk.  That “low risk” or “low volatility” program encouraged leverage which encouraged more new products, in turn attracting more leverage.  Thus, as has been said many times recently, we in the midst of a Great Unwind.  While the drops in stock markets around the world in and of themselves have no fundamental correlation to actual earnings, each day the unwind continues creates a larger and more terrifying drain on real spending and real earnings, such that the tail is now wagging the dog.

A recent broadcast I saw, and I apologetically cannot recall the source, acknowledged that the unregulated derivatives market was allowed to perpetuate, because at least in part, it avoided using the word insurance.  After a moment of research, I found that in 1997 the International Financial Law Review published a paper saying that:

“If credit derivatives are found to be contracts of insurance, in many jurisdictions they will face strict regulation. David Benton, Patrick Devine and Philip Jarvis of Allen & Overy, London, explain how this interpretation can be avoided”

However, if you spoke to anyone selling CDS, OTC options, or other products over the last decade, I imagine (know) that the word insurance was in their verbal arsenal.

With Lehman behind us, massive amounts of hedge fund assets were frozen, large pools of OTC derivatives back by Lehman failed or were frozen, and just five days before the firm filed bankruptcy, Dick Fuld was gloating over the $20+ billion in assets exceeding liabilities the firm had on its balance sheet.  A point that he repeated in his testimony this week in front of the congressional hearing; and a point that sounded more like “this one time at band camp” the more he uttered it.

With the reality that the fed could let firms fail, the reality that a failure can literally happen overnight, and the opacity of counter-party exposure, it is not a surprise that we are now where we are.

What stands to show from my research below, and which admittedly is pure conjecture offered time and time again by others, is that our banking system has been nationalized at least since the S&L crisis.   This is likely why Greenspan, Bernanke and others felt comfortable with the size of the derivatives marketplace; they were comfortable because the majority of the risk was concentrated by three firms who they were very closely keyed into.

Conservatives are only now hemming an hawing about nationalization of the U.S. banking industry, but looking at the data below, and considering that three U.S. banks account for 92% of the 183 trillion in notional derivatives exposure as of June 2008, it is safe to say that the three firms holding most of the derivatives are all too exposed to fail, and as such are insured survival through the current storm.  Also keep in mind that while the derivatives market grew 20 fold over the last 16 years, from 8 trillion to 183 trillion, that the number of deposit institutions has fallen by roughly a third.  This has forced massive concentration of the shadow system into a handful of “firms”.

Three Largest Financial Institutions by Notional Derivative Exposure June 30, 2008

Three Largest Financial Institutions by Notional Derivative Exposure June 30, 2008

A non-stated implied commitment to keeping these firms afloat is not solace for equity holders, as anyone who speculated on FRE or FNM learned.  But like Freddie and Fannie before the bailouts, there is a an implied guarantee.  These three firms are in fact too large, and too exposed to fail.

This is also more than likely why Bank of America, JP Morgan and Citibank have been so involved in forced mergers and fire sales.  (Funny that the fed felt like Lehman had no assets worth keeping American.)  While the balance sheets of these three firms are stretched, I think we are finally past the point where we believe that they are public independently run corporations.

The idea which Alan Greenspan propagated: that derivatives have allowed for risks to spread in an efficient manner; must either indicate that he was high, or that he was expressing his implicit guarantee over those  institutions holding all of the risk.  With the National Debt Clock passing its physical limits, we are at the crossroads where that implicit guarantee has in fact become explicit.  The fact that the Nation Debt Clock was built at a time where 10 trillion was inconceivably large is a wonderful analogy for our collective shortsightedness.

Derivatives (1992-2008)

FDIC - Statistics on Depository Institutions Report: Derivatives (1992-2008)

Sum in Trillions of U.S. Dollars of U.S. Deposit Institution's Notional Derivative Exposue (1992-2008)

Sum in Trillions ($) of U.S. Deposit Institution's Notional Derivative Exposure (1992-2008)

Notional Derivatives as %  of Total Assets (1992-2008)

Notional Derivatives as % of Total Assets (1992-2008)

Sum of All U.S. Deposit Institutions - National, by Number of Institutions (1992-2008)

Sum of All U.S. Deposit Institutions - National, by Number of Institutions (1992-2008)

Sources:
US debt clock runs out of digits
BBC News, 9 October 2008
http://news.bbc.co.uk/2/hi/business/7660409.stm

Investment Outlook: Pyramids Crumbling
Bill Gross, PIMCO, January, 2008
http://www.pimco.com/LeftNav/Featured+Market+Commentary/IO/2008/IO+January+2008.htm

Warren Buffet on Derivatives
Warren Buffett, Berkshire Hathaway Annual Report for 2002
http://www.fintools.com/docs/Warren%20Buffet%20on%20Derivatives.pdf

Bear Stearns second brush with bankruptcy
Roddy Boyd, Fortune, May 2, 2008
http://money.cnn.com/2008/05/02/news/companies/bear_stearns.fortune/index.htm

Lehman Risk Reduction Trading Session and Protocol Agreement
ISDA, September 14, 2008
http://www.isda.org/press/press091408lehman.html

Fox News’ Baier advanced conservative attacks on CRA, repeated falsehood about Rep. Frank
Media Matters, Oct 7, 2008
http://mediamatters.org/items/200810070033?f=h_latest

Financial WMD
Martin D. Weiss, Ph.D., Money and Markets, May 5, 2004
http://www.moneyandmarkets.com/financial-wmd-8784

Credit Derivatives are Not Insurance
David Benton, Patrick Devine and Philip Jarvis, IFLR, November 1997
http://www.iflr.com/Article.aspx?sid=510168

Lehman exposes faults in credit default swaps
Henny Sender, Financial Times, October 7, 2008
http://www.ft.com/cms/s/0/04733ac8-9408-11dd-b277-0000779fd18c.html

$400 Billion Lehman CDS Unwind?
Barry Ritholtz, The Big Picture, October 09, 2008
http://bigpicture.typepad.com/comments/2008/10/lehman-cds-unwi.html

Deconstructing Greenspan
Barry Ritholtz, The Big Picture, October 09, 2008
http://bigpicture.typepad.com/comments/2008/10/deconstructing.html

US Bank Derivative Exposure
Barry Ritholtz, The Big Picture, August 21, 2008
http://bigpicture.typepad.com/comments/2008/08/us-bank-derivat.html

Stick a Fork in It: Moody’s Downgrades 1,923 Subprime RMBS Classes – In Just Two Days
Paul Jackson, HousingWire, April 22, 2008
http://www.housingwire.com/2008/04/22/stick-a-fork-in-it/

Memo to the President-Elect; How Much Capital Does a Bank Need?
The Institutional Risk Analyst, August 21, 2008
http://us1.institutionalriskanalytics.com/pub/IRAstory.asp?tag=301

FDIC: Statistics on Depository Institutions
FDIC, Accessed October 8&9, 2008
http://www2.fdic.gov/sdi/index.asp

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4 Responses to Financial Weapons of Mass Destruction: A Perspective

  1. omgdidisaythat says:

    I ask you, do you think it was deliberate?

  2. […] greenewable wrote an interesting post today onHere’s a quick excerpt(bFunny/b that the fed felt like Lehman had nothing worth keeping American.) While the balance sheets of these three firms are stretched, I think we are finally past the point where we believe that they are public independently run b…/b […]

  3. No intelligent idea can gain general acceptance unless some stupidity is mixed in with it.FernandoPessoaFernando Pessoa, The Book of Disquiet

  4. […] Change Their Websites From dot-com to dot-gov? Just a couple of days ago in a post titled Financial Weapons of Mass Destruction: A Perspective I commented that JP Morgan, Bank of America and Citigroup have been effectively nationalized since […]

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