J.P. Morgan's Big Problem

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.

The Greek Debt Crisis: Another Failure of Derivatives

Once again, derivatives have failed. This time, it's in the Greek sovereign debt crisis. Greece and many EU member nations are dead set on making private holders of Greek bonds take losses in the range of 70% of the face value of the bonds. Not only that, but the EU wants to structure the hit to private bondholders in such a way that it doesn't trigger the requirement for credit default swaps (which are insurance on the bonds) to pay injured bond holders. The legalities involved become rather labyrinthine at the margin. Suffice it to say that the entire bucket of yogurt may well end up in court, where attorneys charging very reasonable fees will secure the funds needed for their children's college tuition.

Court isn't where holders of credit default swaps want to be. Even if, after years of litigation, they receive substantial recompense, they are likely to view CDS's as a flop. A derivatives contract is meaningless if it doesn't transfer risk as advertised. And CDS's on Greek sovereign debt are starting to look pretty hinky.

An interesting question is why is the EU so intent on preventing payouts on the CDS's? Possibly, the EU is concerned that the counterparty risk is concentrated in one or a few institutions, where the losses from payouts might be destabilizing. We're also told that we are supposed to be comforted by the fact that the net exposure in the CDS market for Greek bonds is around 3 billion Euros and that CDS exposures are collateralized, so that counterparties shouldn't be caught in a "run" a la AIG 2008. Okay, 3 billion Euros isn't that much for the world financial system as a whole. But what if it's concentrated in one or two or three firms? As for collateral, what quality are we talking about? If the collateral is EU sovereign bonds (a likely possibility), then one would be forgiven for nervousness about undercollateralization.

In addition, the EU may wish to punish the speculators that bought up Greek sovereign debt at substantial discounts to face value and would profit handsomely if they received CDS payouts (which could be as much as 100 cents on the Euro, although technicalities of the calculation of payouts could result in smaller but potentially still profitable payouts). Ever since hedge funds walloped the British pound in 1992, Europeans have had a fear of financial speculators. Whether that's rightly or wrongly so, CDS holders may be suffering as a result.

Whatever the problem may be, the EU's fears of CDS payouts are evident. Surely, this sordid episode will shake up the market for EU sovereign bonds. Liquidity will fall as private investors realize they can't offload the risk of the political dysfunction that's at the heart of the crisis. EU members have criticized the Volcker rule, arguing that it will discourage big U.S. banks from making markets in EU sovereign bonds. These critics, however, should deal with their own botch-ups before foisting blame on American efforts to safeguard depositors' money. The heart of the EU sovereign debt crisis is that Europeans wanted the benefits of a currency union without having an effective mechanism for dealing with the risks. As bond investors come to realize it's difficult to offload political risk via the CDS market, liquidity in EU sovereign bonds will surely diminish. And the fault lies on the eastern side of the Pond.

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.

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.

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.

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.

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.

Did Dominique Strauss-Kahn Just Mess Up the Derivatives Market?

In the arrest in New York yesterday of Dominique Strauss-Kahn, the managing director and head of the International Monetary Fund, on charges of attempted rape, unlawful imprisonment, and a criminal sex act, the financial press got a rare tabloid-quality story. Financial reporters may be gleeful now, having an opportunity to step back from EBITDA, NAV, SIPC, CDO, and MERS, and turn to allegations of an international financial leader, buck nekked, lying in wait to ambush a hotel maid, chasing her down a hallway and generally behaving like he follows Attila the Hun on Twitter. All reporters need to be good writers, but the truly successful ones have the hunter's instinct for knowing when to pounce. Strauss-Kahn, who might have thought he was the hunter, surely has no trouble hearing the howling of the pack closing in on him.

As a matter of law, Strauss-Kahn remains innocent until proven guilty. But the charges seem to have blown up his political prospects--he had a good chance of becoming the next president of France. And his career in finance is impaired. Another consequence is the new, enlarged bailout for Greece that the EU has been working on may be delayed. Strauss-Kahn, an internationalist who was sympathetic to bailouts, will have trouble getting bail for himself, let alone Greece. He was arrested four hours after the alleged crimes, while seated in a jetliner at JFK International Airport minutes away from leaving for Paris. That's a prosecutor's wet dream (whoops, sorry) for arguing against bail. And it's kind of hard to organize an EU-wide sovereign bailout if you're sitting in jail, eating baloney on white, WWII surplus canned fruit, and week-old brownies. A day of that and never mind haute cuisine. A Croque-monsieur and a demi de biere would seem pretty good.

The IMF says it will soldier on with work on the bailout. And surely it will, because international financial organizations don't justify their existence by saying no. But one can't help but wonder whether some players in the derivatives market who bet on a bigger Greek bailout are wondering if they're going to get margin calls. Even if the arrest of Strauss-Kahn doesn't move credit default swap prices a lot, most traders who play with derivatives mainline margin credit. A little price move can sometimes f . . . foul things up. Strauss-Kahn's arrest by itself won't trigger a financial crisis. But it's something that everyone dealing with the EU sovereign debt morass really didn't need.

There is no derivatives contract covering the risk of the head of an international financial organization being charged with acting really sexy in a wolfish way. No matter how much Wall Street's financial engineers churn and crunch data, there will always be some risks that won't be accounted for. That's why banks and other financial institutions need to be well-capitalized. Even if the next head of the IMF is already well on the way to beatification, you can never completely know when the elephant that is the real world is going to plop a heap of dung on your head.

Is America Ready for Britain's Banker Bonus Tax?

The British government has just announced a one-time 50% tax on banker bonuses. This affects all banks in the U.K., including subsidiaries of foreign banks. Only bonuses larger than 25,000 pounds (about $41,000) are subject to the special tax. This and other British government limitations on bonuses send a pretty clear signal that the Labour government of Prime Minister Gordon Brown will keep a heavy regulatory hand on banking while recovering through taxes some of the $1 trillion or so in assistance the British government provided to banks.

In the U.S., Bank of America announced that it will repay all of the $45 billion in financial aid it received from the TARP program. Among other things, this will free up B of A from the executive compensation limitations imposed by TARP and from paying the U.S. Treasury dividends on B of A preferred stock it owns through TARP. Much of B of A's ability to make this repayment is because of the extensive federal support given to banks, courtesy of the taxpayers. The Fed has funded the banks at a cost of virtually zero, and banks in many instances used that ultra cheap money to invest in U.S. Treasury securities or mortgage-backed securities effectively guaranteed by taxpayers. In other words, B of A is in part repaying TARP money with funds that it directly or indirectly received from taxpayers. The Treasury Department will probably put this down on its TARP scorecard as repayment in full, but how that could be when taxpayers provided some of the money that they received in "repayment"?

It would hardly be unprecedented for taxpayers to receive the short end of the stick. But they may also be receiving the short end of Britain's stick. The British tax on banker bonuses is a not very well-disguised way of inviting banks in London to reduce their riskier activities or move them out of the U.K. Risky activities generate enormous profits, and consequently gratifying bonuses. Since profits are the source of outsized compensation, bankers would move the risky stuff somewhere else and earn their mega bonuses there, before reducing their gaggle of golden egg laying geese.

The U.S. may be a logical place to shift the risky stuff. Financial regulatory reform is gradually slipping down the administration's list of priorities. Virtually all the changes that have been or are being made are the result of administrative and regulatory measures taken by the existing body of agencies (i.e., the Fed, FDIC, Treasury Dept., SEC, CFTC, etc.). Reform of the derivatives markets is taking place to a large degree through industry measures to improve the settlement and clearance process (with stern encouragement from regulators). The bigger issues of monitoring systemic risk and greater transparency in the derivatives markets are stalled in rush hour traffic, as health care reform and federal budgetary matters take front row seats, with a Congressional debate over the wisdom of President Obama's Afghanistan policy close behind. Riskier financial activity could quietly slip across the Atlantic and settle in, with little immediate oversight by the federal government. The American taxpayer might soon again be on the hook for another AIG-type monster bailout, and not even know it until too late.

The problem rests with the too-big-to fail-doctrine, where large financial institutions have the incentive is to conduct risky activities--somewhere--instead of be prudent. The individuals involved in high-octane financial activities rarely lose even if the crazy stuff they do is so systemically bad the federal deficit has to be almost doubled to salvage the economy. Bankers are incentivized to shift risky activity to new venues if they get the boot. Prudence doesn't finance yachts. And if the government--and taxpayers--will absorb the cost of bankers' failures, then all the better (from the bankers' standpoint).

Governments in continental Europe, Canada, and Asia won't welcome derivatives traders gone wild. America is the one remaining major economic power with the infrastructure to support fancy finance. Britain could, in effect, be exporting some of its most difficult financial regulatory problems. And the American taxpayer may be left holding the bag.

Dubai Debt Derivatives Doubts

One mystery of the Dubai debt crisis is the extremely limited information about derivatives contracts for Dubai debt. Credit default swaps protecting debt holders were rising rapidly in price last week as the crisis reached a head. That's hardly surprising, nor is it terribly significant from a systemic question.

The key question is whether we have another AIG--i.e., a financial institution that wrote a large portion of the credit default swaps, or insurance, for Dubai debt protecting debt holders in the event of a default. AIG made a concentrated bet on the value of the real estate market, without any government agencies knowing until it was too late. U.S. taxpayers paid the price. Although the AIG situation should serve as the impetus for meaningful reform of the derivatives market, Wall Street banks have been lobbying vigorously to limit change. Efforts at reform in Europe haven't made much progress, either.

Thus, there is no easy way for regulators anywhere in the world to figure out whether the derivatives risks stemming from the Dubai debt crisis are under control or not. It appears that the banking system of the United Arab Emirates, of which Dubai is a member, is at significant risk. The UAE central bank has already announced a new credit facility to support its banking system. This is what central banks typically do--protect the banking system but not the debtors. Investors holding Dubai debt, especially those in Europe and the U.S., might not benefit much from stabilization of the UAE banking system.

Abu Dhabi, Dubai's oil-rich neighbor, has announced that it will support select Dubai companies, but will not provide blanket protection for Dubai debt holders. In addition, Abu Dhabi may not pay out debt holders 100 cents on the dollar. One suspects that Abu Dhabi will select those companies whose defaults would seriously injure Abu Dhabi's banks and citizens. Holders of other Dubai debt will likely be left looking for any port in the storm.

The problems aren't necessarily limited to Dubai. These crises always have secondary and tertiary effects. Some market participants are getting nervous about debt of other UAE members, and also the debt of certain nations in Eastern Europe and elsewhere. What if credit default swaps for the debt of these other nations were written by a major financial institution that also wrote a lot of Dubai credit default swaps? A major Western financial company could be in serious trouble, but there's no straightforward way to find out if this is the case.

The Dubai crisis is a reminder that the financial crisis of 2007-08 has continued into 2009, as the global economic slowdown takes its toll wherever leverage was used in abundance. And that would include lots of places. Banks worldwide continue to sit on substantial potential losses from residential and commercial real estate. And consumer loan losses have grown along with rising unemployment levels. We're still in the woods, even if some green shoots are visible.

European and U.S. banks have said little or nothing about their Dubai/UAE exposure. Their regulators have said even less. Very possibly, everyone's still scrambling trying to figure out where the problems are. The possibility of another AIG cannot be ignored. After all, the number of financial institutions that are large and well-capitalized enough to be credible issuers of credit default swaps would be quite limited, especially after the AIG mess. If there is a financial institution with concentrated Dubai/UAE/whatever risk, it will probably be a large and well-known one in Europe or the U.S.

Since Abu Dhabi and the UAE won't fully protect holders of Dubai debt, it goes without saying that they won't protect any Western financial institution that's hurting from writing too many Dubai credit default swaps. Perhaps large financial institutions have learned from the AIG experience not to concentrate too much risk in credit default swaps. Then again, movement up the learning curve cannot be assumed. Would it not be possible that Dubai debtholders were willing to buy credit default swaps from a single large dealer because they would anticipate another AIG-style 100 cents on the dollar bailout if bad things happened? Would the Fed hold the line and make them take losses? Or do we think that its still vivid memories of Lehman's collapse would lead it, once again, to speed up the printing presses and churn out more dollars?

As we write this blog, Asian shares are up 2% or more in the belief that the Dubai crisis has been overblown. Maybe so. But remember that it took 15 months or more for the impact on AIG of the real estate and credit crises to become publicly known. And even if there is no AIG, Part Deux looming in the future, the sudden shakiness of a lot of developing world debt will probably lead major banks to pull back even further on lending, contracting the money supply all the more so, and creating more drag on economic activity.

The Dubai crisis illustrates how the government interventions of the last year have slowed, but not prevented, the deleveraging process. Market forces will have their way sooner or later, one way or another. A lot of potential bad debt remains extant, which means that deleveraging will persist for years and demand for credit default swaps will continue to be strong. The risk of another AIG is real, and substantial reform of the derivatives market should be undertaken now, before the Fed and Treasury Department fail in their quest to prevent a second Great Depression.

How the CDO Market Increased Subprime Mortgage Risks

CDOs have been much in the news lately, because of the subprime mortgage mess. Mortgage loan losses, especially among subprime mortgages, have shaken the real estate markets and contributed to the 311 point drop in the Dow Jones Industrial Average on July 26, 2007. While the market turbulence and losses have gotten plenty of headlines, what has been less discussed is how the market for CDOs increased risks and likely exacerbated current problems.

CDOs, as you may know, are entities (usually trusts) that hold pools of mortgages and other loans. The stream of payments (interest and principal) from this pool is subdivided into different segments called "tranches" (which is French for slices). Each tranche has different rights to the stream of payments from the pool. The highest tranche has the best claim, and is the most expensive to buy while offering the lowest rate of return. That's because it also has the lowest risk of nonpayment. As one descends through the tranches, claims to the stream of payments from the pool become ever more subordinate, prices drop and potential rates of return increase. But risks of loss also increase, so you can do very well or very badly in the lowest tranches.

How do the banks that package CDOs sell these things? It's easy enough to understand why someone might buy the highest tranches. They are often comparable to highly rated corporate debt (although the rating agencies seem to have been caught slightly flat-footed by the drop off in the mortgage markets). But where do buyers for the riskier tranches come from?

Some investors seek out risky investments. Hedge fund operators look for risky investments because they have to beat the S&P 500 in order to attract investor money. Pension funds, university endowments and other institutional investors, often seen as bastions of investment prudence, also seek out risk. Here's why.

The 1929 market crash and subsequent Great Depression cured an entire generation of any interest in risky investments. Even the go-go days of the 1960s didn't involve anything approaching the derivatives boom that led to the creation of CDOs. Starting in the 1970s, an idea evolved that taking some degree of risk was good. A well-rounded investment portfolio, it was argued, should include a speculative fillip, something that could boost returns above the boring level of the S&P 500. Sure, greater risk could lead to losses. But if the amount of the portfolio invested in dicey bets was confined, to say 5% or 10%, then the investor would have a good chance of being better off.

The idea that increasing risk was good was marketed by hedge fund operators and other market players who sold risky investment opportunities. Gradually mainstream institutional (and wealthy individual) investors began to accept the idea. Money flowed into the "alternative investment" sector. The hedge fund industry boomed.

As more money flowed into hedge funds and other alternative investments, they needed to find risky investments. After all, a hedge fund operator who claimed to be an investment genius couldn't put his investors' money into S&P 500 index funds. He had to find something that made him look like he deserved the annual 2% of assets and 20% of gains he charged his clients.

The result was that demand for risky investments grew. CDOs, among other things, attained popularity. Subprime mortgages, with their apparent higher risk levels, looked like a good play. They had higher interest rates because they were riskier. But the rising real estate market of the early 2000s usually gave the borrower an escape hatch--if the borrower couldn't repay the loan (especially after an increase in monthly payments), he or she could refinance or sell the house, and the rising real estate market would make that easy. In this way, subprime mortgages appeared to have low risks, even though they were priced as high risks. In the minds of a money manager, that meant they were cheap in comparison to the risks they supposedly had. And if they were cheap, it would make sense to buy a lot of them and generate larger profits. The CDO was a convenient way to sell these high-risk loans to the investment community.

One thing about institutional investors is that they have a lot of money. Even if they divert only 5% or 10% of their portfolios into alternative investments, the result would be a flood of cash. And that's what happened. Money flooded into the alternative investments market. The banks packaging CDOs began looking for more subprime loans. Commissions paid to mortgage brokers for subprime loans increased, and gave them the incentive to steer more customers into subprime mortgages. No doc loans and low doc loans, popularly known among mortgage bankers as "liar loans," became more commonplace. These loans often wouldn't have been made in the past. Now, though, since they weren't being held by the loan originator, but were being sold--first to the banks packaging the CDOs, and eventually to the investors who thought they should be taking more risk--no one had an incentive to exercise caution. The borrowers thought--perhaps erroneously, perhaps because of fraud--that they were getting a good deal. The mortgage brokers collected big commissions while selling the doggy loans to someone else, so they thought they had offloaded the risk. The banks packaging the CDOs made more money with each new deal, while passing the risk onto investors. The hedge funds and institutional investors thought risk was good, so they wanted to buy more risk. Many hedge funds borrowed heavily to buy even more subprime mortgages (or their CDO derivatives), thinking that the more leverage they used, the greater the return on capital they would achieve. The use of leverage magnified demand for subprime loans.

The result was that a ton of imprudent, reckless, ridiculous, and downright stupid mortgage loans were made. The numbers are perhaps impossible to determine at this point, but the rising default rates show that the losses are and will continue to be very large. Because risk came to be seen as a good thing, the market responded to demand and provided more risky investments. A lot more. It literally paid the mortgage industry to create a lot of bad loans. Now there are a lot of losses that have to be suffered.

The sheer quantity of losses is having systemic impact. The bond market is fleeing toward high quality debt and the stock market is becoming more turbulent. Will the world collapse? No. No need to freshen up your secret stocks of batteries, distilled water and freeze-dried food. But the pain will probably increase before it decreases.

The idea that some risk is good for your investment portfolio is a valid idea in a textbook sense. Historical financial data can be used to demonstrate, in a mathematical way, that you would have been better off with a bit of risk during the last 25 years than without it. But the last 25 years have been exceptionally good ones for the financial markets. The 25 years from 1929 to 1954 were little more than break-even, after adjusting for inflation. Past performance is no indication of future performance.

But what happened in the subprime mortgage and CDO markets wasn't just the manifestation of a boilerplate disclosure in the prospectus for every SEC-registered securities offering. We're where we are today because the idea that risk is good became fashionable--too fashionable. And prudence fell out of fashion. Skirts can be made shorter, but there's a limit to how short. And there's a limit to how much risk is good. Investor appetite for risky investments--fueled by incautious marketing by Wall Street--created the monster that we now must deal with. Since the CDO market and hedge fund industry are essentially unregulated, it's unclear how things will play out and who will ultimately hold the bag. One senses that the legal profession will feast; but many others will have a taste of Oliver Twist's gruel.

Skirts eventually became longer, and financial prudence is making a belated re-appearance. Prudence would be advisable for individuals as well as institutions.

Crime News: bad boys sentenced to do the funky chicken. http://www.wtop.com/?nid=456&sid=1201466.

The Derivatives Problem Wall Street Might Have Fixed

One of the largest, and least visible, of the financial markets is the derivatives market. Financial derivatives are contracts that "derive" (or measure) their value by reference to something else. A simple example is the stock option. The option gives its holder the right to purchase the stock on which it is based for a specified price within certain time parameters. The option's value is based primarily on the value of the underlying stock. If the stock increases in value, the option will generally increase in value. And if the stock decreases in value, the option will generally decrease in value.

A more sophisticated kind of financial derivative is the credit derivative. This is a contract that gives the holder protection against loss from defaults in the debt of a company or a country. For example, let's say an investor (usually a large institution) holds bonds of Company A. The investor decides to get some protection in case Company A can't repay its bonds. The investor can engage in a "credit-default swap," which is a transaction where another financial market participant (the "counterparty") agrees to take the risk of a default on Company A's bonds. In other words, the investor buys a kind of insurance against a default by Company A. In this sense, the credit derivatives contract resembles the credit life insurance that many mortgage borrowers are required to buy (if their downpayments are less than 20%)--if the borrower passes away, the credit life policy pays the mortgage loan.

Credit derivative transactions, until recently, were done largely by phone. There is no stock exchange floor, with people running around frantically and dropping slips of paper. There was no electronic quotation system, where bid and ask prices are displayed, and trades are reported. Setting aside the fact that many of the phones have new and strange ways of ringing, the credit derivatives market was much like the over-the-counter stock market of the 1920's and 1930's.

The credit derivatives market was virtually nonexistent ten years ago. Today, it is big--very big. It's reported to involve trillions of dollars of risk coverage, like maybe $35 trillion. Even at $5 a pop, that buys a lot of cups of coffee.

The credit derivatives market has had a wee problem stemming from its rapid growth. Recordkeeping wasn't given exactly the highest priority. Why does recordkeeping matter? After all, enough trees are being killed as it is. But the reason why recordkeeping matters is that records let you figure out who owns what. Today, almost all financial assets consist of entries on paper records or in computerized recordkeeping systems. The green stuff in your wallet is becoming less and less important. If the records aren't good, you don't know what you own. Think about how p.o.'d you'd be if you steadily and patiently saved and invested 10% or 15% of your income each year for 40 years, and then, upon reaching retirement age, found that your financial records were all messed up and you couldn't tell what you had. As boring and painful as it may be, recordkeeping is essential to a sound financial system.

What impact could recordkeeping problems have in the credit derivatives market? Recall the essential purpose of credit derivatives. If a company defaults, the bondholder or other debt holder who bought the default protection would turn to the counterparty on the contract (the insurer, if you will) and smile while extending an open hand. If, however, the counterparty says, "you can't prove I owe you anything because there's no record of the credit derivative transaction," then the bondholder enters a deep vat of yogurt. Lawsuits may be filed, but the only sure winners are lawyers.

In the fall of 2005, Federal Reserve officials got nervous about the recordkeeping in the credit derivatives market. Apparently there were something like 97,000 transactions that were unresolved more than 30 days after they supposedly occurred. As reported in the Wall Street Journal (9/15/05, p. C1), the Federal Reserve Bank of New York convened a meeting and invited 14 major financial institutions to attend. If you're an American financial institution, you never turn down an invitation from the Fed. The Fed had a little credit derivatives coffee klatsch. At the gathering, everyone agreed that they would do better about recordkeeping. Here's how they did, as reported in the press.

Wall Street Journal, Dec. 13, 2005 (P. C6): the 14 major financial firms aim to resolve at 30% of the backlog of open trades by January 31, 2006.

Wall Street Journal, Feb. 17, 2006 (P. C5): the New York Fed said that a 54% reduction in the open trades had been attained.

Wall Street Journal, Sept. 28, 2006 (P. C5): the New York Fed said that 70% of all open trades had been resolved and 85% of the open trades that hadn't been settled for over 30 days had been resolved.

It sounds pretty good. But it isn't entirely clear that all the open credit derivatives trades have been settled. If the counterparties for a small number of large credit derivatives trades cut and run when they should step up to the plate, large amounts of default insurance evaporate and things can become rather unpleasant. Further, there was also a problem of recordkeeping in the equity derivatives market (reported in the Wall Street Journal, Nov. 22, 2006, P. C4). Equity derivatives, as you might guess, are contracts where the risk of a stock, or a basket or index of stocks, falling is covered for a price. If the underlying stock or stocks fall, the counterparty has to compensate the holder of the equity derivative. The New York Fed had began pushing the financial firms to begin straightening out recordkeeping in the equity derivatives market, but it's not clear if those problems were resolved.

The bond markets are getting shakier, with the economy slowing, inflation threatening, consumers running out of home equity to spend, and the mortgage markets having fits. Some companies might not make it. There have been major companies that declared bankruptcy in recent years, which meant defaulting on their bonds. Collins & Aikman Corp. and Delphi Corp., two car parts manufacturers, are examples. One interesting vignette reported in the Wall Street Journal (Dec. 13, 2005, P. C6) is that when Delphi declared bankruptcy, it defaulted on $2 billion of bonds, but the resulting claims on credit derivatives contracts covered $28 billion. That suggests that a lot of people were using credit derivatives to speculate on whether or not Delphi would go in the tank. The ability to use these derivatives to speculate leverages the risks to market players and even the financial system from a big event like a major bankruptcy.

The stock market has been manic-depressive, being irrationally exuberant one day and jumping with a frayed bungee cord the next day. There's a lot of stress in the financial system and the stock market may be more likely to go down than up in the near future. If the market drops significantly or there are more bond defaults, some investors may end up trying to collect on their credit and equity derivatives contracts. If the recordkeeping isn't good, though, they may be in for some bad tummy aches. Recordkeeping cuts into Wall Street's profits. But a loss of investor confidence cuts much deeper. Time will tell whether we'll have a problem.

Strange News: If you're having a bad day, walk by the compliment machine. http://www.wtop.com/?nid=456&sid=1199177.