The baseline problem underlying J.P. Morgan's recently announced $2 billion loss on a credit default swap bet gone bad is that big banks face virtually all economic risks. Banking, as conducted by major money center banks, cuts across essentially all economic sectors, all lines of commerce, all financial instruments, and all asset classes. There are some exceptions. For example, big banks rarely dabble in penny stocks or business startups. And they tend to limit their exposure to junk bonds. But they directly or indirectly play in almost all sandboxes in the economy.
The essential conceit of contemporary financial engineering is that risk somehow can be controlled. It is believed that if you find a clever enough math whiz with an MBA from a sufficiently fancy school, s/he can fashion a derivative for any purpose that will magically (albeit for a fee) transport risk to a distant land from which it will never return. With such magical powers, one need not be prudent and limit exposure to risky assets. One need only have a smart enough financial engineer to fashion a seemingly appropriate hedge.
Derivatives can work, and work well, when the risk they're meant to mitigate is narrow and well-defined. For example, futures contracts for red winter wheat serve salutary purposes when appropriately used by farmers, grain companies and speculators.
But when derivatives are deployed to mitigate wide-ranging and vaguely defined risks, their limitations come into play. Press reports indicate that J.P. Morgan's management directed its chief investment office to mitigate the risks of economic deterioration in Europe. This, to say the least, is a rather large, complex and wide ranging problem. Things in Europe can go downhill for a variety of reasons, not all of which are easily defined or predicted. The murkier a situation, the more difficult it becomes to fashion appropriate hedges. And if the hedges aren't entirely appropriate, their imperfections may have be hedged in turn. Reports in the financial press indicate the mandate from J.P. Morgan's management seems to have morphed into a net position that bet on improved financial health for a number of major corporations. Such a bet wouldn't seem the intuitively obvious way to hedge against a downturn in Europe.
As with all financial firms, J.P. Morgan's most important asset is its reputation. Since the 2007-08 financial crisis, its reputation has been golden. J.P. Morgan avoided unduly large real estate risks. It bought Bear Stearns at the government's behest, quelling incipient panic in the financial system. Its earnings were relatively stable, compared to its competitors. While the latter downsized to ditch hinky assets and offload risk, J.P. Morgan became the largest bank in America.
But such golden reputations become a burden, because the market expected J.P. Morgan to remain golden. Given that big money center banks face virtually all economic risks, this becomes a harder and harder job as time passes. Skilled risk managers and corporate executives might be able to anticipate most risks most of the time. But no one can predict all risks all the time, and a financial institution facing the length and breadth of economic risks borne by major money center banks will stumble sooner or later. Indeed, the longer a bank's winning streak, the greater the chance the next quarter will be a bad one.
Management sitting on a winning streak will understandably want to keep the streak going. But they must consider whether or not they can. Not all risks can be hedged or managed. Much of the "hedging" that goes on in the financial markets consists of using apples to hedge oranges. The two sides of the hedge are not mirror images of each other, but approximations. If the approximations are pretty close, a well-capitalized firm can get by. But that "if" gets bigger and bigger as derivatives positions get larger and as some derivatives are used to hedge risk factors in other hedges (which may have been the case at J.P. Morgan). When risk managers and management fail to recognize that the magic doesn't work in all situations, they get a morass.
Recognizing one's limits is an ancient and highly effective means of risk management. Not taking a risk, or offloading it, eliminates the possibility that it will later bite your butt. Being the biggest bank doesn't necessarily mean that you're the best bank. Appreciate that derivatives are imperfect financial instruments, and because of their newness, their imperfections are imperfectly understood. Given the inability to comprehend all risks or hedge them, having a shipload of capital may be best way for a bank to safeguard its future.
Banks typically trade at comparatively low multiples of earnings per share. That's because of the plethora of risks financial firms typically face. The siren call of the derivatives market is that, for a fee, a bank can hedge its way out of problems instead of having to manage them. These sirens have claimed a number of victims since the 2007-08 financial crisis, and now they appear to have lured J.P. Morgan onto a rocky coast.
Showing posts with label credit default swaps. Show all posts
Showing posts with label credit default swaps. Show all posts
Monday, May 14, 2012
Sunday, January 22, 2012
The Greek Debt Crisis and the Failure of Credit Default Swaps
The Greek debt crisis, from which the entire European sovereign debt morass arises, comes down to a dispute between the Greek government and a group of private investors who hold large amounts of Greek bonds. These investors, many of whom appear to be hedge funds, are refusing to swallow as much loss as the Greek government demands. The Greek government is threatening default. The investors respond by, in essence, saying, "Go ahead. Make my day."
If the Greek government defaults, the investors will turn to credit default swaps they bought to protect against losses on Greek bonds. These CDS's are like insurance coverage against a Greek default. The government wants the investors to "voluntarily" agree to concessions, which wouldn't trigger CDS payouts. The investors have bargained hard, apparently emboldened by the knowledge that they can turn to their insurers if negotiations fail and Greece defaults.
Although usually described as insurance, the CDS's in this instance are being used for speculative purposes. The hedge funds may actually profit more by forcing the Greek government to default, than by working toward a consensual resolution. A default could have severe consequences, triggering a credit crisis in Europe that could circumnavigate the global financial system at the speed of a broadband Internet connection and plaster the world economy with a major credit crunch. Economic dislocation and recession would surely ensue.
When an "insurance" contract turns out to encourage recklessness, it has failed. Insurance is meant to protect against outsized loss, not to encourage insureds to foster or instigate losses. CDS's appear to be motivating speculators to disrupt a nation's finances. That's undesirable, no matter how you look at it.
Regulators and the financial services industry have done little to prevent derivatives, and credit default swaps in particular, from wrecking the financial system, as happened in 2008. Now, derivatives again pose a similar danger. People who don't learn from their mistakes are doomed to make them again. A sense of impending doom is growing.
If the Greek government defaults, the investors will turn to credit default swaps they bought to protect against losses on Greek bonds. These CDS's are like insurance coverage against a Greek default. The government wants the investors to "voluntarily" agree to concessions, which wouldn't trigger CDS payouts. The investors have bargained hard, apparently emboldened by the knowledge that they can turn to their insurers if negotiations fail and Greece defaults.
Although usually described as insurance, the CDS's in this instance are being used for speculative purposes. The hedge funds may actually profit more by forcing the Greek government to default, than by working toward a consensual resolution. A default could have severe consequences, triggering a credit crisis in Europe that could circumnavigate the global financial system at the speed of a broadband Internet connection and plaster the world economy with a major credit crunch. Economic dislocation and recession would surely ensue.
When an "insurance" contract turns out to encourage recklessness, it has failed. Insurance is meant to protect against outsized loss, not to encourage insureds to foster or instigate losses. CDS's appear to be motivating speculators to disrupt a nation's finances. That's undesirable, no matter how you look at it.
Regulators and the financial services industry have done little to prevent derivatives, and credit default swaps in particular, from wrecking the financial system, as happened in 2008. Now, derivatives again pose a similar danger. People who don't learn from their mistakes are doomed to make them again. A sense of impending doom is growing.
Wednesday, November 2, 2011
The Greek Referendum: What European Union?
Is there even such a thing as the European Union? The Greek prime minister, George Papandreou, has just announced an impromptu referendum to be held toward the end of this year, in which the Greek people will decide if they will accept the austerity and other measures required by the EU's bailout of Greece. The referendum was not previously mentioned by Greek leaders to the EU, and the EU is displeased, to put it mildly. It's holding back a bailout payment of 8 billion Euros that was to have been given to Greece in mid-November. Greece hasn't back down, and EU leaders are suggesting that Greek voters be asked to decide whether or not Greece should remain in the EU. Who knows? The Greek electorate may respond with a digital salute.
The Greek prime minister also faces a no confidence vote this Friday, Nov. 4, 2011. His legislative majority has been shrinking, and he officially has just barely enough votes to survive. If the no confidence vote fails, Greece will hold early elections. Those could further delay implementation of the EU's bailout plan.
The referendum and no confidence vote throw a massive wrench into the EU's governance "process." As it is, the EU has no established way to deal with a problem like the ongoing sovereign debt crisis, in which its very existence could be threatened. Europe's leaders have been winging it, meeting every week, and issuing innumerable upbeat press releases to manipulate the financial markets upward. Somehow, this ad hoc process produced a back of the envelope bailout that might at least delay the day of reckoning. But all the EU's efforts have now been suspended by the unexpected announcement of the Greek referendum and no confidence vote.
The referendum and no confidence vote demonstrate that there simply is no European Union. At its moment of greatest crisis, the fate of the EU rests on a snap decision by a Greek politician to hold a plebiscite and a no confidence vote. No one else in the EU signed off on this sui generis procedure. Yet, the EU, its currency, its financial system and its economic fortunes rest on the political vagaries of a country whose GDP is maybe 2% of the EU's GDP. There isn't a European Union. The EU has no rules, no governance process, no decision makers and no efficacy. It's like a group of people who have jammed themselves onto a very small life raft and are working against each others' efforts to keep the thing from tipping over.
If the EU blows up, the rest of the world will be dragged down as well. All this because of the political dysfunction of a nation with 0.5% of the world's GDP. That the fate of the European Union, and the world's financial system and economy, should rest on the electoral process of a small nation like Greece suggests that the interconnectedness of the world's financial system and economy has gone too far. Technology, derivatives and other linkages allow capital--and more importantly, financial risk--to flash around the globe almost instantaneously. While that's good when life is copacetic, reality is that some days are rainy. Today's hyperquick, hyperactive, and opaque financial system guarantees not only that capital flows immediately to the most attractive profit opportunity, but also that risk and financial contagion move equally fast in unpredictable, and therefore unhedged, ways. It may be time to establish significant limits on the extent to which financial risk can be palmed off. When faced with risk, people have a tendency to become responsible. But when you can pass the hot tamale to someone else, expediency trumps maturity. What we desperately need today is responsible behavior.
The only firewall left for the financial system is the taxpayer. Because taxpayers are becoming increasingly stressed, central banks have printed or will resort to printing money. This isn't a solution, just a kick of the can down the road. The Greek prime minister's decision to hold a referendum and no confidence vote serves as a reminder of a truth that is rarely acknowledged: there is no way of the current financial crisis without serious pain for everyone. The Greek prime minister is asking Greeks to grow up, face the fact that they will have to endure tough times, and agree to take their castor oil. Sooner or later, the rest of the world will have to do the same. But their politicians and other leaders continue to spin tales of Lake Wobegon, where everyone is in the top 1% and occupies only executive suites.
The Greek prime minister also faces a no confidence vote this Friday, Nov. 4, 2011. His legislative majority has been shrinking, and he officially has just barely enough votes to survive. If the no confidence vote fails, Greece will hold early elections. Those could further delay implementation of the EU's bailout plan.
The referendum and no confidence vote throw a massive wrench into the EU's governance "process." As it is, the EU has no established way to deal with a problem like the ongoing sovereign debt crisis, in which its very existence could be threatened. Europe's leaders have been winging it, meeting every week, and issuing innumerable upbeat press releases to manipulate the financial markets upward. Somehow, this ad hoc process produced a back of the envelope bailout that might at least delay the day of reckoning. But all the EU's efforts have now been suspended by the unexpected announcement of the Greek referendum and no confidence vote.
The referendum and no confidence vote demonstrate that there simply is no European Union. At its moment of greatest crisis, the fate of the EU rests on a snap decision by a Greek politician to hold a plebiscite and a no confidence vote. No one else in the EU signed off on this sui generis procedure. Yet, the EU, its currency, its financial system and its economic fortunes rest on the political vagaries of a country whose GDP is maybe 2% of the EU's GDP. There isn't a European Union. The EU has no rules, no governance process, no decision makers and no efficacy. It's like a group of people who have jammed themselves onto a very small life raft and are working against each others' efforts to keep the thing from tipping over.
If the EU blows up, the rest of the world will be dragged down as well. All this because of the political dysfunction of a nation with 0.5% of the world's GDP. That the fate of the European Union, and the world's financial system and economy, should rest on the electoral process of a small nation like Greece suggests that the interconnectedness of the world's financial system and economy has gone too far. Technology, derivatives and other linkages allow capital--and more importantly, financial risk--to flash around the globe almost instantaneously. While that's good when life is copacetic, reality is that some days are rainy. Today's hyperquick, hyperactive, and opaque financial system guarantees not only that capital flows immediately to the most attractive profit opportunity, but also that risk and financial contagion move equally fast in unpredictable, and therefore unhedged, ways. It may be time to establish significant limits on the extent to which financial risk can be palmed off. When faced with risk, people have a tendency to become responsible. But when you can pass the hot tamale to someone else, expediency trumps maturity. What we desperately need today is responsible behavior.
The only firewall left for the financial system is the taxpayer. Because taxpayers are becoming increasingly stressed, central banks have printed or will resort to printing money. This isn't a solution, just a kick of the can down the road. The Greek prime minister's decision to hold a referendum and no confidence vote serves as a reminder of a truth that is rarely acknowledged: there is no way of the current financial crisis without serious pain for everyone. The Greek prime minister is asking Greeks to grow up, face the fact that they will have to endure tough times, and agree to take their castor oil. Sooner or later, the rest of the world will have to do the same. But their politicians and other leaders continue to spin tales of Lake Wobegon, where everyone is in the top 1% and occupies only executive suites.
Tuesday, October 4, 2011
Have Derivatives Nailed Us Again?
As the stock market has plunged in recent weeks, banks stocks have often led the way into the abyss. This, in part, is because we don't know enough about the major banks.
Lack of information casts doubt on the value of a stock. Pigs in a poke sell for less than pigs out in the open. Banks, as we know from centuries of financial panics and runs, are volatile institutions that can seem healthy one day and on the verge of collapse the next. A bank's standing depends not only on its operational performance and financial condition, but also its public image. Gossip, whispers and rumors all can affect its image, and therefore its stability. Lack of information can inflame the impact of fast-moving negative news.
Europe's banks hold large quantities of troubled EU sovereign debt. The amounts are not entirely clear, but are hefty--hundreds of billions and maybe even trillions of Euros worth of dodgy debt. American banks are linked to European banks, among other ways through the settlement and clearance process for negotiable instruments, interbank loans, securities transactions, and derivatives deals. The first three exposures are pretty easily quantified. The last is not. Since most derivatives transactions are still direct, over-the-counter deals, there is no centralized venue for collecting information about many of them. No one knows if counterparty risk is concentrated in one or a few firms (a la AIG, circa 2008). No one knows if nonstandard transactions have created atypical risk profiles.
Banks often assert that they hedge their derivatives exposures. But there is no easy way to verify that. Hedges can be collateralized in whole, in part, or not at all. They can depend on creditworthy counterparties or hinky ones. They may be perfect, mirror-image hedges, or they might be approximations that don't fit any better than a used cheap suit bought in a thrift store. The Long Term Capital Management mess of 1997 resulted in part from "hedges" that turned out to be ill-fitting cheap suits.
The lack of information means that we can't tell how bad the derivatives exposures of big banks are. And that means we don't know what their stocks are worth. Hence bank stocks nose dive in times of doubt.
The Dodd-Frank legislation was supposed to cast sunlight on the derivatives market. Financial regulators are, as far as can be discerned, proceeding with perhaps some deliberate speed. The securities industry has wheeled out shiploads of lobbyists to to impede progress. Profit margins, like mushrooms, thrive in darkness. So the industry welcomes transparency as much as the Lakota welcomed Custer.
For all we know, the ghost of AIG-2008 lurks and derivatives might have done us in again. Remember that derivatives transfer risk, and an American bank doing a derivatives deal with a European bank or other firm may take on European risks as a result. Comparable risk transfer can occur if an American bank does a derivatives deal with an Asian bank that offsets its exposure by doing a mirror-image deal with a European bank. In such ways, derivatives can expand an American bank's risk profile well beyond its normal depositary and lending activities. Thus, derivatives can exacerbate the problem of too big to fail. But there's no ready way to tackle this problem, because information is lacking.
Europe's financial ministers today stopped another market rout with some talk therapy, leaking the word that they are vigorously studying the possibility of boosting the capitalization of Europe's banks. But they didn't say they had any concrete plans or proposals, just that everyone should feel good because they are concerned. The market bounced back, betting on positive rumors and gossip. But recent experience shows that bouncing balls readily fall back after going up, and the market will fall back again without something more concrete that inspires confidence. Given the darkness in the derivatives market, building confidence will be more easily said than done.
Lack of information casts doubt on the value of a stock. Pigs in a poke sell for less than pigs out in the open. Banks, as we know from centuries of financial panics and runs, are volatile institutions that can seem healthy one day and on the verge of collapse the next. A bank's standing depends not only on its operational performance and financial condition, but also its public image. Gossip, whispers and rumors all can affect its image, and therefore its stability. Lack of information can inflame the impact of fast-moving negative news.
Europe's banks hold large quantities of troubled EU sovereign debt. The amounts are not entirely clear, but are hefty--hundreds of billions and maybe even trillions of Euros worth of dodgy debt. American banks are linked to European banks, among other ways through the settlement and clearance process for negotiable instruments, interbank loans, securities transactions, and derivatives deals. The first three exposures are pretty easily quantified. The last is not. Since most derivatives transactions are still direct, over-the-counter deals, there is no centralized venue for collecting information about many of them. No one knows if counterparty risk is concentrated in one or a few firms (a la AIG, circa 2008). No one knows if nonstandard transactions have created atypical risk profiles.
Banks often assert that they hedge their derivatives exposures. But there is no easy way to verify that. Hedges can be collateralized in whole, in part, or not at all. They can depend on creditworthy counterparties or hinky ones. They may be perfect, mirror-image hedges, or they might be approximations that don't fit any better than a used cheap suit bought in a thrift store. The Long Term Capital Management mess of 1997 resulted in part from "hedges" that turned out to be ill-fitting cheap suits.
The lack of information means that we can't tell how bad the derivatives exposures of big banks are. And that means we don't know what their stocks are worth. Hence bank stocks nose dive in times of doubt.
The Dodd-Frank legislation was supposed to cast sunlight on the derivatives market. Financial regulators are, as far as can be discerned, proceeding with perhaps some deliberate speed. The securities industry has wheeled out shiploads of lobbyists to to impede progress. Profit margins, like mushrooms, thrive in darkness. So the industry welcomes transparency as much as the Lakota welcomed Custer.
For all we know, the ghost of AIG-2008 lurks and derivatives might have done us in again. Remember that derivatives transfer risk, and an American bank doing a derivatives deal with a European bank or other firm may take on European risks as a result. Comparable risk transfer can occur if an American bank does a derivatives deal with an Asian bank that offsets its exposure by doing a mirror-image deal with a European bank. In such ways, derivatives can expand an American bank's risk profile well beyond its normal depositary and lending activities. Thus, derivatives can exacerbate the problem of too big to fail. But there's no ready way to tackle this problem, because information is lacking.
Europe's financial ministers today stopped another market rout with some talk therapy, leaking the word that they are vigorously studying the possibility of boosting the capitalization of Europe's banks. But they didn't say they had any concrete plans or proposals, just that everyone should feel good because they are concerned. The market bounced back, betting on positive rumors and gossip. But recent experience shows that bouncing balls readily fall back after going up, and the market will fall back again without something more concrete that inspires confidence. Given the darkness in the derivatives market, building confidence will be more easily said than done.
Wednesday, August 31, 2011
Will the Credit Default Swaps Market Become Less Predictable?
Yesterday's Wall Street Journal (8/30/11) reported on P. C11 that a hedge fund manager named Mark Brodsky asked the International Swaps and Derivatives Association to rule that a "bankruptcy credit event" (which triggers a dealer's obligation to pay under a credit default swap) has occurred for a company that hasn't actually entered into bankruptcy proceedings. A lot may ride on the response to this request. Brodsky runs a hedge fund called Aurelius Capital Management LP, which holds credit default swaps for Texas Cooperative Electric Holdings Co. According to Aurelius Capital, Texas Cooperative Electric is insolvent and has admitted as much. Aurelius Capital would like to collect on its CDS's without having to wait for an actual bankruptcy filing (which would constitute a bankruptcy credit event triggering a dealer obligation to pay on the CDS's).
A decision by ISDA that the insolvency of Texas Cooperative Electric is enough to trigger the obligation to pay on the CDS's may transform the CDS market. CDS's have been regarded as similar to insurance contracts, which pay when discrete, well-defined events occur. If the debtor doesn't pay the underlying debt on time or files for bankruptcy, then the dealer that sold the CDS has to pay its customer. But insolvency is a much broader concept, and may depend on how one defines and assigns valuations to the debtor's "assets" and "liabilities." Lawyers and accountants can argue until pigs fly about whether or not a debtor is insolvent. It's not unreasonable to believe that just about all major American banks were insolvent in parts of 2008-09; and it's possible that one or more remain insolvent today. Perfectly sane people rationally entertain suspicions that Europe's major banks might now be insolvent. Very possibly, most industrialized nations of the world are insolvent. There are shiploads of CDS's outstanding with respect to the debt of all the major banks and just about all the world's industrialized nations.
If Aurelius Capital can collect on its Texas Cooperative Electric CDS's without an actual bankruptcy filing, a lot of market participants holding an exponentially larger quantity of bank and sovereign debt CDS's might be similarly entitled to collect because the relevant underlying debtors are insolvent. The major CDS dealers might become shaky at that point--assuming they can even figure out their net claims or liabilities, which could be a convoluted process given that we still don't have much transparency in the trading, settlement or clearance of CDS's, Dodd-Frank notwithstanding. Since the major CDS dealers are among the world's largest banks, a lot might be at stake.
Financial crises, like the debacle in 2007-08, tend to occur because something unexpected happens. In the case of the events in 2007-08, it was the drop in the real estate market on a national basis, something that hadn't happened in a very long time and therefore wasn't expected to happen again. Today, the European sovereign debt crisis could trigger another financial crisis because market participants continue to believe that there is no problem so great that some expedient muddling by EU governments can't forestall the denouement for yet a couple more months. Excessive expediency allows underlying problems to fester and fester--and then blow up when least expected.
A change in the way CDS's are interpreted, as requested by Aurelius Capital, could fluster a lot of people playing in the CDS market. That market might become less predictable, and then who knows what would happen. If there's one thing the CDS market hasn't expected, it would be a legal interpretive issue like this one, which could, in one fell swoop, affect the length and breadth of the market--and with it, the entire financial system. So keep an eye out for the outcome.
A decision by ISDA that the insolvency of Texas Cooperative Electric is enough to trigger the obligation to pay on the CDS's may transform the CDS market. CDS's have been regarded as similar to insurance contracts, which pay when discrete, well-defined events occur. If the debtor doesn't pay the underlying debt on time or files for bankruptcy, then the dealer that sold the CDS has to pay its customer. But insolvency is a much broader concept, and may depend on how one defines and assigns valuations to the debtor's "assets" and "liabilities." Lawyers and accountants can argue until pigs fly about whether or not a debtor is insolvent. It's not unreasonable to believe that just about all major American banks were insolvent in parts of 2008-09; and it's possible that one or more remain insolvent today. Perfectly sane people rationally entertain suspicions that Europe's major banks might now be insolvent. Very possibly, most industrialized nations of the world are insolvent. There are shiploads of CDS's outstanding with respect to the debt of all the major banks and just about all the world's industrialized nations.
If Aurelius Capital can collect on its Texas Cooperative Electric CDS's without an actual bankruptcy filing, a lot of market participants holding an exponentially larger quantity of bank and sovereign debt CDS's might be similarly entitled to collect because the relevant underlying debtors are insolvent. The major CDS dealers might become shaky at that point--assuming they can even figure out their net claims or liabilities, which could be a convoluted process given that we still don't have much transparency in the trading, settlement or clearance of CDS's, Dodd-Frank notwithstanding. Since the major CDS dealers are among the world's largest banks, a lot might be at stake.
Financial crises, like the debacle in 2007-08, tend to occur because something unexpected happens. In the case of the events in 2007-08, it was the drop in the real estate market on a national basis, something that hadn't happened in a very long time and therefore wasn't expected to happen again. Today, the European sovereign debt crisis could trigger another financial crisis because market participants continue to believe that there is no problem so great that some expedient muddling by EU governments can't forestall the denouement for yet a couple more months. Excessive expediency allows underlying problems to fester and fester--and then blow up when least expected.
A change in the way CDS's are interpreted, as requested by Aurelius Capital, could fluster a lot of people playing in the CDS market. That market might become less predictable, and then who knows what would happen. If there's one thing the CDS market hasn't expected, it would be a legal interpretive issue like this one, which could, in one fell swoop, affect the length and breadth of the market--and with it, the entire financial system. So keep an eye out for the outcome.
Tuesday, July 26, 2011
European Credit Default Swaps: EU 15, Speculators Love?
An undercurrent of the EU sovereign debt crisis is that the Euro zone nations detest the speculators they believe have been gambling on the outcome of the Greek and other bailout efforts. Hedge funds and perhaps some investment banks dabble in credit default swaps protecting against defaults by various Euro zone nations as a way to gain speculative profits. While CDS's may have originated as hedging instruments, just about any financial instrument can be used to speculate as well as hedge. And CDS's, like many derivatives, can be traded on a leveraged basis, which makes them all the more appealing as speculative investments.
Euro zone governments loath speculators in CDS's of EU member nations' debt. Although CDS's nominally take their value from the market for the underlying financial instrument, there is a belief that derivatives markets can affect the markets for underlying financial instruments. In other words, a lot of CDS speculation on a Greek default might push the value of Greek bonds lower, increasing the potential for default by raising the market interest rates Greece must pay. The toxic interaction in the 1987 U.S. stock market crash between stocks and a type of derivatives contract called portfolio insurance fuels such beliefs. Portfolio insurance purported to guarantee the value of portfolios. Mutual funds, pension funds and other institutional investors flocked to this product (which is now extinct). When stocks dipped on Black Monday (Oct. 19, 1987), portfolio insurers began short selling underlying stocks in order hedge themselves against further stock drops. That short selling only increased the downward pressure on stocks, which triggered more selling and short selling. This increased selling impelled more short selling by portfolio insurers, which served only to fuel more panic. The market dropped a total of 22% that day, the greatest percentage drop ever, not excluding the 1929 stock market crash.
The EU's second bailout for Greece involves an expectation of a "voluntary" bond exchange by private holders of Greek debt for longer term debt, something that underlies the credit agencies' view of this bailout as a default. This exchange will entail a 20% loss for those holders. The exchange feature would lower the market value of Greek bonds and, perhaps, might be the sort of thing against which a CDS holder would expect protection. But the International Swaps and Derivatives Association, a trade organization composed of derivatives dealers, has decided that CDS obligations will not be triggered by the second Greek bailout because it doesn't change the terms for all holders of Greek debt. In other words, if a hedge fund holds a CDS on Greek debt and was hoping for a payout because the EU's bailout, part deux, would be considered a default by the rating agencies, it's out of luck.
How many speculators have been hurt by this decision, and how large their losses are, is unknown. The amount is probably not trivial, because all the volatility surrounding the Greek debt situation would provide a plenitude of speculative opportunities. Don't expect a lot of publicity about these losses. The speculators, knowing the EU member nations are probably quietly gloating over this victory, have plenty of reason to lick their wounds in silence. And don't be surprised if the EU, in the next bailout of Greece, Ireland, Portugal or whomever, doesn't try to structure things so that CDS's payment requirements again aren't triggered, and the speculators get spanked again.
Euro zone governments loath speculators in CDS's of EU member nations' debt. Although CDS's nominally take their value from the market for the underlying financial instrument, there is a belief that derivatives markets can affect the markets for underlying financial instruments. In other words, a lot of CDS speculation on a Greek default might push the value of Greek bonds lower, increasing the potential for default by raising the market interest rates Greece must pay. The toxic interaction in the 1987 U.S. stock market crash between stocks and a type of derivatives contract called portfolio insurance fuels such beliefs. Portfolio insurance purported to guarantee the value of portfolios. Mutual funds, pension funds and other institutional investors flocked to this product (which is now extinct). When stocks dipped on Black Monday (Oct. 19, 1987), portfolio insurers began short selling underlying stocks in order hedge themselves against further stock drops. That short selling only increased the downward pressure on stocks, which triggered more selling and short selling. This increased selling impelled more short selling by portfolio insurers, which served only to fuel more panic. The market dropped a total of 22% that day, the greatest percentage drop ever, not excluding the 1929 stock market crash.
The EU's second bailout for Greece involves an expectation of a "voluntary" bond exchange by private holders of Greek debt for longer term debt, something that underlies the credit agencies' view of this bailout as a default. This exchange will entail a 20% loss for those holders. The exchange feature would lower the market value of Greek bonds and, perhaps, might be the sort of thing against which a CDS holder would expect protection. But the International Swaps and Derivatives Association, a trade organization composed of derivatives dealers, has decided that CDS obligations will not be triggered by the second Greek bailout because it doesn't change the terms for all holders of Greek debt. In other words, if a hedge fund holds a CDS on Greek debt and was hoping for a payout because the EU's bailout, part deux, would be considered a default by the rating agencies, it's out of luck.
How many speculators have been hurt by this decision, and how large their losses are, is unknown. The amount is probably not trivial, because all the volatility surrounding the Greek debt situation would provide a plenitude of speculative opportunities. Don't expect a lot of publicity about these losses. The speculators, knowing the EU member nations are probably quietly gloating over this victory, have plenty of reason to lick their wounds in silence. And don't be surprised if the EU, in the next bailout of Greece, Ireland, Portugal or whomever, doesn't try to structure things so that CDS's payment requirements again aren't triggered, and the speculators get spanked again.
Thursday, May 27, 2010
Banks Get Murkier
Just as an incipient credit crunch lurks in Europe's weeds, the financial condition of major banks is getting murkier. Spain's credit crisis is mostly a matter of banks being overleveraged (its government isn't in bad fiscal shape, compared to many Western nations). Some Spanish banks may not be marking their real estate assets to market. Spain's government is merging banks rather than liquidating them, which might obscure rather than illuminate the financial weaknesses of the banking sector (kind of like the way grocery stores mix good string beans in with the crappy ones to make lazy shoppers buy some, well, crap).
In the U.S., Citigroup and Bank of America have admitted to misclassifying in financial reports repo transactions (which are loans) as asset sales. This echoes the infamous Repo 105 strategem used by Lehman Brothers to reduce reported leverage levels. Both Citi and B of A claim the amounts were immaterial and that the misclassifications were errors. Nevertheless, billions of dollars of transactions were involved, and a curious investor might wonder, in light of the magnitude involved, how sound the banks' internal controls were.
U.S. banks continue to benefit from accounting rule changes made by regulators last year under political pressure from Congress, which loosened requirements to mark assets to market. It's possible that the major U.S. banks hold hundreds of billions of dollars worth of hinky assets that are carried at valuations above market prices. With residential real estate wobbly and commercial real estate falling, the banks can't continue indefinitely to wear rose-tinted glasses when compiling their financial statements.
One reason why the stock market goes on volatility frenzies is that investors are ambushed by surprises. The sovereign debt crisis began with Greece 'fessing up last fall to having a lot more debt than it had previously acknowledged. Things went downhill from there as it became clearer that various EU members had debt problems. Spanish and other European banks are having trouble selling or rolling over commercial paper in the U.S. Credit default swaps protecting against defaults on bank debt have been rising in price. While many failures contributed to the current problems, a failure of proper accounting was among the most important.
"Garbage in, garbage out" is a time-honored axiom from computer science. It also applies to the financial markets. Bad or inadequate information results in poor pricing. When the truth comes out, abrupt shifts in valuation can be expected. When bank accounting goes hinky, the soundness of the financial system can be endangered. Taxpayers must then gird themselves for more bailouts. Bank regulators don't always encourage transparency, in the fear that the truth will spark runs on troubled institutions. But in today's computerized, Internet-connected world, there are no secrets. At least, not for long, and when the word belatedly gets out, the run is all the more panicked. Full, fair and timely accounting and disclosure by banks, nations and other debtors is essential to a healthy financial system. Such should be a primary goal of financial regulatory reform in the U.S., Europe and elsewhere. Expediency, however, militates in the other direction. Sunshine is the best disinfectant, but human frailty the greatest source of continued infection.
In the U.S., Citigroup and Bank of America have admitted to misclassifying in financial reports repo transactions (which are loans) as asset sales. This echoes the infamous Repo 105 strategem used by Lehman Brothers to reduce reported leverage levels. Both Citi and B of A claim the amounts were immaterial and that the misclassifications were errors. Nevertheless, billions of dollars of transactions were involved, and a curious investor might wonder, in light of the magnitude involved, how sound the banks' internal controls were.
U.S. banks continue to benefit from accounting rule changes made by regulators last year under political pressure from Congress, which loosened requirements to mark assets to market. It's possible that the major U.S. banks hold hundreds of billions of dollars worth of hinky assets that are carried at valuations above market prices. With residential real estate wobbly and commercial real estate falling, the banks can't continue indefinitely to wear rose-tinted glasses when compiling their financial statements.
One reason why the stock market goes on volatility frenzies is that investors are ambushed by surprises. The sovereign debt crisis began with Greece 'fessing up last fall to having a lot more debt than it had previously acknowledged. Things went downhill from there as it became clearer that various EU members had debt problems. Spanish and other European banks are having trouble selling or rolling over commercial paper in the U.S. Credit default swaps protecting against defaults on bank debt have been rising in price. While many failures contributed to the current problems, a failure of proper accounting was among the most important.
"Garbage in, garbage out" is a time-honored axiom from computer science. It also applies to the financial markets. Bad or inadequate information results in poor pricing. When the truth comes out, abrupt shifts in valuation can be expected. When bank accounting goes hinky, the soundness of the financial system can be endangered. Taxpayers must then gird themselves for more bailouts. Bank regulators don't always encourage transparency, in the fear that the truth will spark runs on troubled institutions. But in today's computerized, Internet-connected world, there are no secrets. At least, not for long, and when the word belatedly gets out, the run is all the more panicked. Full, fair and timely accounting and disclosure by banks, nations and other debtors is essential to a healthy financial system. Such should be a primary goal of financial regulatory reform in the U.S., Europe and elsewhere. Expediency, however, militates in the other direction. Sunshine is the best disinfectant, but human frailty the greatest source of continued infection.
Sunday, February 14, 2010
The Greek Debt Coverup: Headed for Cable TV?
If you like The Sopranos, you'll like the Greek debt crisis. As events unfold and people win or lose, the veneer of civility in the financial markets, diaphanous in the best of times, may be wearing through completely. People who play in the financial sandbox can be very poor losers. Perhaps we are seeing that in the latest episode of the Greek debt drama.
The New York Times reports that, in 2000 and 2001, the government of Greece entered into derivatives deals with Goldman Sachs which allowed it to downplay its true debt levels. http://www.nytimes.com/2010/02/14/business/global/14debt.html?hp. Details are scant. The transactions are described as swaps, although they appear to take the form of sales of revenue streams like the proceeds of the Greek national lottery and the landing fees collected by Greece's airports. Evidently, the transactions were structured to let the Greek government avoid characterizing them as debt. That seems to have helped the government present a sufficiently conservative fiscal picture to meet the requirements for EU membership.
If an American public company did something like this, it might well find itself receiving SEC subpoenas. If it acted deliberately with an intent to mislead investors, its executives might have the unsettling experience of testifying before a federal grand jury (which means answering questions without having your lawyer present).
State and local governments in America aren't immune from federal regulation. When Orange County, California did some dumb derivatives deals in the 1990s, it and a couple of its officials were sanctioned by the SEC for failing to disclose serious risks of loss that later materialized. See http://www.sec.gov/litigation/litreleases/lr14792.txt. When the Massachusetts Turnpike Authority, in constructing the infamous Big Dig in Boston, failed to disclose nasty cost overruns, it and its one-time chairman were also sanctioned by the SEC. http://www.sec.gov/litigation/admin/33-8260.htm. So the principle of full and fair disclosure by governments isn't unfamiliar to the U.S. financial markets. But, in 2001, when Greece joined the EU, it evidently wasn't required to reveal how it had gussied up its financial statements.
The Times story indicates that the Greek derivatives deals were in 2002 revealed to be loans, after accounting standards changed. And, to the Greek government's credit, it reportedly turned down a financing transaction proposed by Goldman in late 2009 that would have allowed it to defer recognition of public health care expenses. (We can't help wondering what that involved--the sale of the Parthenon?)
It's interesting that this story appears now, right after the EU announced, albeit vaguely, that it would somehow not let the Greek debt situation deteriorate into financial panic. It's unclear how the Times picked up on these derivatives deals. But they must have had a source or two or three, because newspapers don't know about this sort of stuff on their own. And the source(s) must have talked to the Times recently. Otherwise, why wouldn't the Times have run the story, say, three months ago when the Dubai debt mess brought sovereign debt problems prominently into focus?
Who might the source(s) be? Logic and experience indicate market player(s) who might have taken a hit when Greek debt recovered after the EU announcement, perhaps holder(s) of credit default swaps. CDS's on Greek debt fell in value after the EU made its love-those-Greeks announcement. You don't have to have any substantive exposure to a relevant debt to buy a credit default swap. A CDS can be used to make a pure side bet, like putting money down in Las Vegas on the outcome of the Super Bowl. A player making a pure bet would have taken losses without any counterbalancing gain from underlying debt when the EU embraced Greece (okay, not quite). As we noted earlier, players in the financial markets sandbox can be very pouty losers. Maybe a speculator or two contacted the Times and clued them in, hoping that public revelation of these machinations might call into question the accuracy even now of the Greek government's accounting, and reverse recent price trends in credit default swaps.
Heightening suspicions is the fact that the Times also just ran a story about a Greek government statistician who found himself living in a world of controversy when he was allegedly associated with inaccuracies that understated the Greek government's budget deficit by more than two-thirds. See http://www.nytimes.com/2010/02/14/world/europe/14greek.html?ref=business. This individual, no longer employed by the Greek government and now living in New York to "escape from Greece," insists that he isn't at fault. Regardless of who understated the Greek budget deficit, why would an obscure Greek statistician suddenly be of interest to one of the most widely-read newspapers in the world? What are the chances that two stories about the inaccuracies of Greece's national accounting would randomly run in The New York Times the weekend after the EU reluctantly rides to the semi-rescue and some people lose money betting against Greek debt?
The probity of Greece's national accounting is a legitimate subject for the press, and it's quite common for newspapers to run related stories on the same day. There's no reason to think the Times did anything improper by running these stories when it did. But the Times surely didn't know about Greece's national accounting problems all on its own. Financial market players have always tried to spark the dissemination of information favoring their investments. In addition, financial crises produce volatile prices, which give banks, hedge funds and other big bonus boys the opportunity to make outsized profits. With millions and maybe billions on the line, these folks play for keeps (as in, they want to make and keep profits). They might hope that the relative equanimity produced by last week's announcement of EU support for Greece will be disturbed by these recent stories about dodgy Greek national accounting. Perhaps some holders will start selling their suddenly not so gorgeous bonds. Other players, perhaps more speculative, might step in and buy. Credit default swaps could again become fashionable.
The nastiness index appears to be rising. The Greek and other Euro bloc sovereign debt problems remain far from resolution. Stay tuned. So far, no one has been wrapped in chains and tossed off a boat. But the plot thickens.
The New York Times reports that, in 2000 and 2001, the government of Greece entered into derivatives deals with Goldman Sachs which allowed it to downplay its true debt levels. http://www.nytimes.com/2010/02/14/business/global/14debt.html?hp. Details are scant. The transactions are described as swaps, although they appear to take the form of sales of revenue streams like the proceeds of the Greek national lottery and the landing fees collected by Greece's airports. Evidently, the transactions were structured to let the Greek government avoid characterizing them as debt. That seems to have helped the government present a sufficiently conservative fiscal picture to meet the requirements for EU membership.
If an American public company did something like this, it might well find itself receiving SEC subpoenas. If it acted deliberately with an intent to mislead investors, its executives might have the unsettling experience of testifying before a federal grand jury (which means answering questions without having your lawyer present).
State and local governments in America aren't immune from federal regulation. When Orange County, California did some dumb derivatives deals in the 1990s, it and a couple of its officials were sanctioned by the SEC for failing to disclose serious risks of loss that later materialized. See http://www.sec.gov/litigation/litreleases/lr14792.txt. When the Massachusetts Turnpike Authority, in constructing the infamous Big Dig in Boston, failed to disclose nasty cost overruns, it and its one-time chairman were also sanctioned by the SEC. http://www.sec.gov/litigation/admin/33-8260.htm. So the principle of full and fair disclosure by governments isn't unfamiliar to the U.S. financial markets. But, in 2001, when Greece joined the EU, it evidently wasn't required to reveal how it had gussied up its financial statements.
The Times story indicates that the Greek derivatives deals were in 2002 revealed to be loans, after accounting standards changed. And, to the Greek government's credit, it reportedly turned down a financing transaction proposed by Goldman in late 2009 that would have allowed it to defer recognition of public health care expenses. (We can't help wondering what that involved--the sale of the Parthenon?)
It's interesting that this story appears now, right after the EU announced, albeit vaguely, that it would somehow not let the Greek debt situation deteriorate into financial panic. It's unclear how the Times picked up on these derivatives deals. But they must have had a source or two or three, because newspapers don't know about this sort of stuff on their own. And the source(s) must have talked to the Times recently. Otherwise, why wouldn't the Times have run the story, say, three months ago when the Dubai debt mess brought sovereign debt problems prominently into focus?
Who might the source(s) be? Logic and experience indicate market player(s) who might have taken a hit when Greek debt recovered after the EU announcement, perhaps holder(s) of credit default swaps. CDS's on Greek debt fell in value after the EU made its love-those-Greeks announcement. You don't have to have any substantive exposure to a relevant debt to buy a credit default swap. A CDS can be used to make a pure side bet, like putting money down in Las Vegas on the outcome of the Super Bowl. A player making a pure bet would have taken losses without any counterbalancing gain from underlying debt when the EU embraced Greece (okay, not quite). As we noted earlier, players in the financial markets sandbox can be very pouty losers. Maybe a speculator or two contacted the Times and clued them in, hoping that public revelation of these machinations might call into question the accuracy even now of the Greek government's accounting, and reverse recent price trends in credit default swaps.
Heightening suspicions is the fact that the Times also just ran a story about a Greek government statistician who found himself living in a world of controversy when he was allegedly associated with inaccuracies that understated the Greek government's budget deficit by more than two-thirds. See http://www.nytimes.com/2010/02/14/world/europe/14greek.html?ref=business. This individual, no longer employed by the Greek government and now living in New York to "escape from Greece," insists that he isn't at fault. Regardless of who understated the Greek budget deficit, why would an obscure Greek statistician suddenly be of interest to one of the most widely-read newspapers in the world? What are the chances that two stories about the inaccuracies of Greece's national accounting would randomly run in The New York Times the weekend after the EU reluctantly rides to the semi-rescue and some people lose money betting against Greek debt?
The probity of Greece's national accounting is a legitimate subject for the press, and it's quite common for newspapers to run related stories on the same day. There's no reason to think the Times did anything improper by running these stories when it did. But the Times surely didn't know about Greece's national accounting problems all on its own. Financial market players have always tried to spark the dissemination of information favoring their investments. In addition, financial crises produce volatile prices, which give banks, hedge funds and other big bonus boys the opportunity to make outsized profits. With millions and maybe billions on the line, these folks play for keeps (as in, they want to make and keep profits). They might hope that the relative equanimity produced by last week's announcement of EU support for Greece will be disturbed by these recent stories about dodgy Greek national accounting. Perhaps some holders will start selling their suddenly not so gorgeous bonds. Other players, perhaps more speculative, might step in and buy. Credit default swaps could again become fashionable.
The nastiness index appears to be rising. The Greek and other Euro bloc sovereign debt problems remain far from resolution. Stay tuned. So far, no one has been wrapped in chains and tossed off a boat. But the plot thickens.
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