Aliens: The Next Chapter
Monday, March 31st, 2008In the Alien film quadrilogy, actress Sigourney Weaver plays Ellen Ripley, a tough, no-nonsense heroine who helps beat back an onslaught of extraterrestrial creatures that seem hell-bent on destroying mankind.
The two reports that follow suggest we may be seeing life imitate art. Only in this case, the lead character is the Federal Reserve and derivatives are the monstrosities that threaten to engulf and destroy the global financial system.
The question is: will this real-life drama have a Hollywood ending?
“Fed’s Rescue Halted a Derivatives Chernobyl” by Ambrose Evans-Pritchard (Daily Telegraph):
When the Federal Reserve stepped in to save Bear Stearns, most people had no idea what was at stake, writes Ambrose Evans-Pritchard
We may never know for sure whether the Federal Reserve’s rescue of Bear Stearns averted a seizure of the $516 trillion derivatives system, the ultimate Chernobyl for global finance.
“If the Fed had not stepped in, we would have had pandemonium,” said James Melcher, president of the New York hedge fund Balestra Capital.
“There was the risk of a total meltdown at the beginning of last week. I don’t think most people have any idea how bad this chain could have been, and I am still not sure the Fed can maintain the solvency of the US banking system.”
All through early March the frontline players had watched in horror as Bear Stearns came under assault and then shrivelled into nothing as its $17bn reserve cushion vanished.
Melcher was already prepared - true to form for a man who made a fabulous return last year betting on the collapse of US refinance securities. He is now turning his sights on Eastern Europe, the next shoe to drop.
“We’ve been worried for a long time there would be nobody to pay on the other side of our contracts, so we took profits early and got out of everything. The Greenspan policies that led to this have been the most irresponsible episode the world has ever seen,” he said.
Fed chairman Ben Bernanke has moved with breathtaking speed to contain the crisis. Last Sunday night, he resorted to the “nuclear option”, invoking a Depression-era clause - Article 13 (3) of the Federal Reserve Act - to be used in “unusual and exigent circumstances”.
The emergency vote by five governors allows the Fed to shoulder $30bn of direct credit risk from the Bear Stearns carcass. By taking this course, the Fed has crossed the Rubicon of central banking.
To understand why it has torn up the rule book, take a look at the latest Security and Exchange Commission filing by Bear Stearns. It contains a short table listing the broker’s holding of derivatives contracts as of November 30 2007.
Bear Stearns had total positions of $13.4 trillion. This is greater than the US national income, or equal to a quarter of world GDP - at least in “notional” terms. The contracts were described as “swaps”, “swaptions”, “caps”, “collars” and “floors”. This heady edifice of new-fangled instruments was built on an asset base of $80bn at best.
On the other side of these contracts are banks, brokers, and hedge funds, linked in destiny by a nexus of interlocking claims. This is counterparty spaghetti. To make matters worse, Lehman Brothers, UBS, and Citigroup were all wobbling on the back foot as the hurricane hit.
“Twenty years ago the Fed would have let Bear Stearns go bust,” said Willem Sels, a credit specialist at Dresdner Kleinwort. “Now it is too interlinked to fail.”
The International Swaps and Derivatives Association says the vast headline figures in the contracts are meaningless. Positions are off-setting. The actual risk is magnitudes lower.
The Bank for International Settlements uses a concept of “gross market value” to weight the real exposure. This is roughly 2 per cent of the notional level. For Bear Stearns this would be $270bn, or so.
“There is no real way to gauge the market risk,” said an official
“We don’t know how much is backed by collateral. We don’t know what would happen in a crisis, and if we don’t know, nobody does,” he said.
Under the rescue deal, JP Morgan Chase will take over Bear Stearns’ $13.4 trillion contracts - lock, stock, and barrel.
But JP Morgan is already up to its neck in this soup, with $77 trillion of contracts. It will now have $90 trillion on its books, a sixth of the global market.
Risk is being concentrated further. There are echoes of the old reinsurance chains at Lloyd’s, but on a vaster scale.
The most neuralgic niche is the $45 trillion market for credit default swaps (CDS). These CDS swaps are a way of betting on the credit quality of companies without having to buy the underlying bonds, which are less liquid. They have long been the bête noire of New York Fed chief Timothy Geithner, alarmed that 10 banks make up 89 per cent of the contracts.
“The same names show up in multiple types of positions. These create the potential for squeezes in cash markets, magnifying the risk of adverse dynamics,” he said.
“They could increase systemic risk, by amplifying rather than dampening the movement in asset prices,” he said.
This is what happened as the banking crisis gathered pace. The CDS spreads measuring default risk on Bear Stearns debt rocketed from 246 to 792 in a single day on March 13 amid - untrue - rumours that the broker was preparing to invoke bankruptcy protection.
Was it the spike in spreads that set off the panic run on Bear Stearns by New York insiders? Or are the CDS spreads merely serving as a barometer?
In the old days it was hard for speculators to take “short” bets on bonds. Credit derivatives open up a whole new game.
“It is now much easier to short credit, ” said James Batterman, a derivatives expert at Fitch Ratings in New York. “CDS swaps can be used for speculation, and that can cause skittish markets to overshoot,” he said.
For now the meltdown panic has subsided. Yet the hottest document flying around the City last week was a paper by Barclays Capital probing what might happen in a counterparty default.
It is not for bedtime reading. Direct losses from a CDS breakdown alone could be $80bn, but the potential risks are much greater.
In theory, the contracts are matching. One sides loses, the other gains, operating through a neutral counterparty (ie Bear Stearns). But if the system seizes up, the mechanism is not neutral at all. It becomes viciously one-sided.
“Upon the default of the counterparty, [traded] derivatives would be immediately repriced, with spreads widening dramatically,” said the Barclays report.
This is “gap risk”, the stuff of trading nightmares. Fortunes can vanish in a moment.
One side would suddenly be trapped with staggering losses on their books. Yet the winners would be unable to collect their prize from the insolvent bank in the middle. It would take years to unravel all the claims in court. By then the financial landscape would be a scene of carnage.
Warren Buffett famously described derivatives as “weapons of mass financial destruction”. The analogy is suspect, of course. Allied troops never found the alleged weapons in Iraq.
This time, Washington’s pre-emptive shock and awe may have been well-advised.
“In the Fed’s Cross Hairs: Exotic Game” by Gretchen Morgenson (New York Times):
In the week or so since the Federal Reserve Bank of New York pushed Bear Stearns into the arms of JPMorgan Chase, there has been much buzz about why the deal went down precisely as it did.
Its primary purpose, according to regulators, was to forestall a toppling of financial dominoes on Wall Street, in the event that Bear Stearns skidded into bankruptcy and other firms began falling apart as well.
But a closer look at the terms of this shotgun marriage, and its implications for a wide array of market participants, presents another intriguing dimension to the deal. The JPMorgan-Bear arrangement, and the Bank of America-Countrywide match before it, may offer templates that allow the Federal Reserve to achieve something beyond basic search-and-rescue efforts: taking some air out of the enormous bubble in the credit insurance market and zapping some of the speculators who have caused it to inflate so wildly.
Of course, it could be simple coincidence that the rescues caused billions of dollars (or more) in credit insurance on the debt of Countrywide and Bear Stearns to become worthless. Regulators haven’t pointed at concerns about credit default swaps, as these insurance contracts are called, as reasons for the two takeovers. (And Bank of America’s chief executive, Kenneth D. Lewis, has flatly denied that his deal with Countrywide was at the behest of regulators.)
Yet an effect of both deals, should they go through, is the elimination of all outstanding credit default swaps on both Bear Stearns and Countrywide bonds. Entities who wrote the insurance — and would have been required to pay out if the companies defaulted — are the big winners. They can breathe a sigh of relief, pocket the premiums they earned on the insurance and live to play another day.
Investors who bought credit insurance to hedge their Bear Stearns and Countrywide bonds will be happy to receive new debt obligations from the acquirers in exchange for their stakes. They are simply out the premiums they paid to buy the insurance.
On the other hand, the big losers here are those who bought the insurance to speculate against the fortunes of two troubled companies. That’s because the value of their insurance, which increased as the Bear and Countrywide bonds fell, has now collapsed as those bonds have risen to reflect their takeover by stronger banks.
We do not yet know who these speculators are, but hedge fund and proprietary trading desks on Wall Street are undoubtedly among them.
The derivatives market is huge, unregulated and opaque because participants undertake the transactions privately and don’t record them in a central market. The growth in the market and the potential for disruption, as a result of its size, has surely caused regulators to lose plenty of sleep.
Credit default swaps were created as innovative insurance contracts that bondholders could buy to hedge their exposure to the securities. Like a homeowner’s policy that insures against a flood or fire, the swaps are intended to cover losses to banks and bondholders when companies fail to pay their debts. The contracts typically last five years.
Recently, however, speculators have swamped the market, using the derivatives to bet on companies they view as troubled. That has helped the swaps become some of the fastest-growing contracts in the derivatives world. The value of the insurance outstanding stood at $43 trillion last June, according to the Bank for International Settlements. Two years earlier, that amount was $10.2 trillion.
But before a contract can pay out to a buyer of the insurance, a company must default on its bonds. In both the Countrywide and Bear Stearns takeovers, the companies were saved before they could default. Both deals also specify that the acquiring banks assume the debt of the target.
As a result, the insurance policies that once covered Bear Stearns and Countrywide bonds will become the obligations of much stronger issuers: JPMorgan and Bank of America. No payouts are coming, guys.
So consider all those swaggering hedge fund managers and Wall Street proprietary traders who recorded paper gains on their credit insurance bets as the prices of Bear and Countrywide bonds fell. Now they must reverse those gains as a result of the rescues. If they still hold the insurance contracts, they are up a creek — and the Fed just took away their paddles.
An interesting side note: It’s likely that JPMorgan, the biggest bank in the credit default swap market, had a good deal of this kind of exposure to Bear Stearns on its books. Absorbing Bear Stearns for a mere $250 million allows JPMorgan to eliminate that risk at a bargain-basement price. JPMorgan declined to comment on the size of its portfolio of credit default swaps.
We’ve yet to hear a peep about losses stemming from the Countrywide and Bear Stearns debacles. That doesn’t mean they aren’t there. Remember all those months that the subprime problem was supposed to have been “contained”?
IF we’ve learned anything from this year-long walk down the credit-crisis trail, it is that speculators on the losing end of such deals don’t typically volunteer that they have suffered enormous hits in their portfolios until they are forced to — often when they’re on the brink of collapse.
Do the Bear Stearns and Countrywide deals represent a regulatory template? Both had the same types of winners and losers. Bondholders won, while stockholders and credit insurance owners lost. Although there aren’t that many big banks left that are financially sound enough to buy out the next failure, it’s a pretty good bet that future rescues will look a lot like these.
Maybe it’s just a coincidence that both these deals involve wiping out billions of dollars worth of outstanding credit default swaps linked to Bear Stearns and Countrywide bonds.
Still, helping to trim the risk just a tad in the $43 trillion credit default swap market certainly qualifies as a side benefit. Had either Bear Stearns or Countrywide defaulted, the possibility that some of the parties couldn’t afford to pay what they owed to insurance holders posed a real risk to the entire financial system.
It’s pretty clear that some major losses are floating around out there on busted credit default swap positions. Investors in hedge funds whose managers have boasted recently about their astute swap bets would be wise to ask whether those gains are on paper or in hand. Hedge fund managers are paid on paper gains, after all, so the question is more than just rhetorical.
Losses, losses, who’s got the losses?
On Wall Street, no one can hear you scream.