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.

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.

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.

Taxpayer Liability for Banks: the Missing Link in Balancing the Federal Budget

As if the federal budget balancing debate weren't complicated enough, a key issue is absent from the discussion. Virtually no attention is being paid to the potential budget-busting problem of taxpayer liability for the banking system. Although this is a contingent liability, it can wreak astounding havoc when the banking system hits the fan. Ireland illustrates the problem.

Like so many other nations, Ireland rode to seeming prosperity on a rising real estate market. Its banks were instrumental in financing this bubble. When Lehman Brothers collapsed in September 2008, Irish banks rapidly slipped off the precipice. Their stock prices fell and a liquidity crisis loomed. The Irish government moved posthaste to stem the panic, guaranteeing some $570 billion of bank liabilities (which should be compared to Ireland's GDP of approximately $170 billion). Eventually, the Irish government nationalized one major bank, Anglo Irish. While the Irish government's direct debt is about 65% of GDP (not much different from the U.S. government's direct debt), its guarantee of bank liabilities vastly increased its potential obligations. The resulting morass was so bad that Ireland needed an EU bailout earlier this year.

The U.S. government (and American taxpayers) are on the hook for the liabilities of the largest American banks. Not officially, but we all know they'll get a bailout if they need one. In addition, taxpayers are liable for the housing banks--Fannie Mae, Freddie Mac, the FHA and Ginnie Mae. The amounts of all these contingent liabilities are unclear but likely very large. Illiquid real estate assets held by banks (so-called Level 3 assets) may be overvalued by hundreds of billions. Vast numbers of defaulted mortgages remain in limbo as the foreclosure mess crawls toward a resolution that will probably entail more losses for banks. The continued decline of the real estate market means more mortgages going underwater, and probably more defaults.

In addition, the largest banks have trillions of dollars of derivatives exposure. Much of the derivatives exposure is hard to see right now. Current accounting standards allow banks sometimes to net derivatives assets against derivatives liabilities. Netting means we don't see them on balance sheets. Once international accounting standards replace U.S. generally accepted accounting principles (probably within a couple of years), a lot of current netting of derivatives holdings would likely have to be unwound. Balance sheets of the largest banks could balloon by more than $7 trillion, in the aggregate. America's GDP is around $14 trillion, while annual federal spending is around $3.5 trillion. Readers may painfully recall that during the 2007-08 financial crisis, derivatives assets had a scary way of losing value while derivatives liabilities remained unwavering. Taxpayers would be on the hook for the losses. Reining in the amounts of bank derivatives exposure may be necessary to reducing the potential bite on taxpayers.

So, we can see that balancing the budget doesn't just mean getting expenditures down and government revenues up. It also means limiting contingent liabilities. Ireland's government didn't flagrantly overspend. Profligate lending by too big to fail Irish banks made it fail. Fortunately, Ireland's not too big to be bailed out by the EU. But there's no brother big enough to bail out America. Truly balancing the U.S. government's budget requires limiting taxpayer exposure to the banking system.

Progress on that front is painfully slow. The Volcker Rule is constraining some of the riskier activity. But reform of the derivatives market is hard to spot, even on sunny days at high noon. Banks remain Brobdingnagian in size, and executive compensation may soon run wild again. Implementation of the Dodd-Frank provisions for improved financial regulation is hindered by lack of funding. Fannie, Freddie and the FHA guarantee almost all new mortgages. Proposals for limiting the burdens they place on taxpayers will be obstinately contested by the real estate industry. Although neither Republicans or Democrats want to face the tough issues in balancing the budget--entitlement programs like Medicare, Medicaid and Social Security--we will eventually have to reform those programs. But all the pain and controversy we will endure squabbling over entitlements will be for naught if there is another financial crisis. And another crisis hardly seems any less likely than the one we still haven't recovered from.

The SEC's Case: Goldman, Too, Danced to the Music

Today's enforcement case by the SEC against Goldman Sachs for allegedly making misrepresentations in the marketing of a synthetic CDO called ABACUS 2007-AC1 signifies many things. Goldman hasn't formally responded in court, but has denied certain assertions by the SEC. We won't attempt to predict the legal outcome at this early stage. But a few observations seem fair.

First, the case signals a return by the SEC and its Division of Enforcement to the big leagues, after a painful stint in Triple A. The agency will be on the front pages of newspapers tomorrow--this time in a positive light. Of course, the SEC needs to get a good result--victory at trial or a favorable settlement. But its willingness to take on the most imperious doyenne on Wall Street--which couldn't even get its CEO on the train from New York to Washington for a meeting with the President late last year (are they now rethinking that one?)--reflects pugnaciousness badly needed in the regulatory structure.

Second, the case will strengthen the movement toward reforming financial regulation, with a special nod in favor of the Volcker rule--there's really no good reason for insured deposits to subsidize this sort of behavior. Additionally, the two principal victims were European banks. The SEC charges will only fuel the already robust movement in Europe to rein in the Wild West antics of the derivatives markets--in part because the case broadly echoes Goldman's reported role in helping Greece pretty up its balance sheet, thus effectively increasing Greece's risk of overextending itself, and then creating a trading vehicle in London to short sell Greece.

Third, regardless of whether or not Goldman is legally liable, one has to wonder what on earth Goldman's management was thinking when they signed off on this deal? By early 2007, when the deal was done, Goldman was aware of the growing weakness in the mortgage markets. Certain e-mails were quoted in the SEC's complaint which make that clear and Goldman hasn't denied the contents of the e-mails. When a bank knows a market is poised for problems, why structure a deal that involves selling long positions in that market? Surely there are less problematic ways to make money. Goldman made $15 million in fees for structuring this deal (although it claims to have lost $90 million in the end). It could pay out a lot more than $15 million to injured investors if it loses at trial. And even if it turns out that Goldman didn't break any rules, why would it have benefited from putting clients in a position of significant potential for loss? These weren't dot com IPOs. These were interests in mortgages, supposedly a pretty safe investment. Clients would reasonably have expected that they wouldn't be put at major risk by a silk stocking firm like Goldman when they were looking for comparative safety.

The old Goldman Sachs (primarily, the firm before it went public), had a strong sense of self-awareness and propriety, turning away from many deals and their potential fees simply because they would have been too risky for clients and therefore too risky to Goldman's reputation and standing. Today's Goldman seems to have lost that sense of judgment and moderation.

What may have really been going on, we speculate, could be that Goldman wanted the fees. Although $15 million isn't much for an investment bank that makes billions a year, it is a lot to individual Goldman executives, like the man who was named as a defendant by the SEC, Fabrice Tourre. Tourre, alleged to be 31 today, was in 2007 exactly at the young age where ambitious investment bankers push extremely hard to climb the career ladder toward anticipated stardom--old enough to have significant responsibility and latitude, but frequently not enough experience to know that cents and sense--especially common sense--are very different things. Young, high powered execs will push, push, and push their deals because they're focused on bonus time. But a mature financial institution can't just knuckle under to its young guns. In a highly visible and highly regulated industry like financial services, how you generate revenues matters as much as how much you generate. Chuck Prince, former CEO of Citigroup, famously said (and we paraphrase) that as long as the music in the mortgage markets was playing, Citigroup had to get up and dance. It did, and it got clobbered. Now we have Goldman, by early 2007 seemingly aware of the growing difficulties in the mortgage markets, yet also wanting to dance while the music was playing.

The nightly cleaning crews at Goldman's offices surely earn modest wages. But those are honest wages earned in exchange for a fair night's work. With today's allegations about ABACUS 2007-AC1, we have Goldman, which has tried for decades to present itself as a cut above all those scumbags on Wall Street, not comparing well to its cleaning staff. Goldman was supposed to be smarter, a protector of clients' interests, a firm that took the long view and would forgo current income for the sake of propriety. Its elite, blue blood aura provided special entree in Washington, as well as on Main Street. People thought of Goldman as clever, very quick on its feet, highly profitable, yet thoughtful before it was greedy. That bubble has now burst, and GS is revealed to have feet of clay. On one level, that's reassuring, but on many others, it's not. Expect financial regulatory reform legislation to be enacted by the mid-term elections.

Robber Barons Redux in the Derivatives Market?

A recent story from Bloomberg.com reported that two large banks, Goldman Sachs and J.P. Morgan Chase, are using their market power to secure extra large helpings of collateral in derivatives transactions with hedge funds. http://www.bloomberg.com/apps/news?pid=20601109&sid=af6uIAFTSorY. For example, Goldman reportedly obtained $110 billion more in collateral on derivatives transactions than it paid out. In effect, it got $110 billion in low cost funding that it could reinvest at a profit. J.P. Morgan Chase netted $37 billion in a similar way.

On one level, we're glad that hedge funds dancing in the derivatives market are subsidizing Goldman and J.P. Morgan. Otherwise, the Fed might feel compelled to print more money to ensure plenty of cheap funding for the too large to fail.

But the Bloomberg story states that these two behemoths of the financial markets had their way with counterparties because of their market power. In the post-2008 financial markets, there are only a few firms that offer some derivatives products sought by hedge funds, and those few evidently make their customers pay full freight and perhaps more.

On the level of economic theory, oligopolistic behavior is undesirable because the oligopolists extract "monopoly rents" from their customers--i.e., profits above the level that a truly competitive market would provide. This misallocation of economic resources enhances the power of the oligopoly, which can use that power to further entrench itself and secure more monopoly rents. To restate the point in plain English, oligopoly power allows the already megawealthy to become even more indescribably rich.

Surely we taxpayers, who have already subsidized Wall Street to the tune of multi-billions, are gratified to learn that those clever kids at Goldman and J.P. Morgan Chase can look forward to even more wealth. But let's also consider the impact of this collateral disparity on market risks. The derivatives market has a zero-sum quality. If a risk is transferred from one party to another, it doesn't disappear. It simply lands in the second party's lap, who must then figure out what to do with the hot tamale. In a similar way, if more, rather than less, of the hedge fund community's funding is transferred to money center banks, that leaves less for the hedge funds. Prudent hedge fund managers, after having their arms twisted by bank counterparties for extra collateral, would shrink their asset bases in order to keep risk levels in line with their reduced circumstances.

But this is Wall Street. Profits talk and prudence walks. Reduce your assets, and you reduce your money making potential. Do we really think that, just because GS and JPM have reduced their risk levels, their counterparties will do so as well? Or might it just possibly be that their counterparties would simply live more dangerously?

We've seen this video before. It was called The Grasping Counterparties Who Ruined AIG's Entire Day. Recall that AIG reached the brink because its derivatives counterparties, with the largest being Goldman, demanded more collateral than AIG could deliver. Surrounded by a pack of ravenous counterparties, AIG would have been torn to shreds except that the federal government appeared in the nick of time with $180 billion to drive (or rather, buy) off the wolfpack. Goldman claims it was fully hedged from AIG risk. But in order to do God's work it took the taxpayers' money anyway.

If Goldman's and J.P. Morgan Chase's counterparties are now at greater risk, where would that risk fall if the markets turn sour? It's possible that the derivatives markets have become more fragile because of the increasing concentration of market power in the hands a few money center banks. Locating any such fragility is difficult, because the absence of financial regulatory reform leaves us with only the fog of opacity of the derivatives market, circa 2008--well, 2010. Of course, if there is a blowup, the Fed can always print some more money. And that's okay, because there never, ever will be any inflation again. At least, that seems to be close to what some high ranking government officials have told us and they couldn't be wrong, could they?

Financial Derivatives and the Business Cycle Redux

The Dow Jones Industrial Average ended up 91 today. But if you were a banker, you didn't have such a good day.

Today, the Federal Reserve and other government agencies issued a "Statement on Loss Mitigation Strategies for Servicers of Residential Mortgages." Written in the understated parlance of financial regulation, the statement urges banks and other institutions that "service" mortgages (i.e., collect the monthly payments, transfer debt payments to the holders of the mortgages, pay out money escrowed for taxes, etc.) to try to work things out so that distressed mortgage borrowers don't lose their homes. The regulators mention various "loss mitigation" strategies, such as deferring some loan payments, rolling delinquent payments into principal (which is another way of deferring them), conversion of adjustable rate loans into fixed rate loans, and even a reduction of the principal of the loan.

Defaulting homeowners who may have been lured into adjustable rate or interest only loans they didn't fully understand may see a little light in the darkness coming from this statement. However, let's not overlook the fact that the statement focuses on "loss mitigation," meaning the reduction of loss. It's not talking about loss to the homeowner. It means loss to the bank. The statement notes that "prudent workout arrangements that are consistent with safe and sound lending practices are generally in the long-term best interest of both the financial institution and the borrower." In other words, any workout has to benefit the lender as well as the borrower, and those borrowers who are in really big trouble may not get a workout.

Why would the Fed and other regulators encourage loan workouts? Stated otherwise, what would happen if there weren't workouts? More homeowners would default, and losses on their mortgages would have to be recorded. Initially, the loss might appear to fall on the hedge funds and other investors that bought the CDO tranches that have an interest in the income stream from these mortgages. However, in many circumstances, the banks that provided the mortgages for the CDOs might have to buy back defaulting mortgages. That would mean much of the loss would fall on the banks. The banks, in turn, could try to make the mortgage brokers who initially originated the loans buy back the defaulting mortgages. But many of those mortgage brokers are now in bankruptcy proceedings, and their buyback obligations aren't worth the price of a pack of chewing gum.

So the loss on many defaulting mortgages will fall on the only remaining deep pockets--the banks. This is the loss the regulators want to mitigate, because if it gets too large, the financial system takes on the consistency of jello. And given the apparently vast amount of losses that may bubble up from the subprime morass, the threat of jello must be taken seriously.

There's more. September is also the month when banks have to begin trying to refinance several hundred billions (yes, billions, not millions) of dollars of loans for leveraged buyouts. Many of these deals have been temporarily financed by bridge loans extended by the major banks (see our blog at http://blogger.uncleleosden.com/2007/07/private-equitys-traffic-jam-in-bond.html). However, the banks don't want to be long term financiers of these deals, and would like to sell bonds and other loans to hedge funds and other institutional buyers to replace the bridge loans. That way, if the leverage buyouts fail, yogurt would fall on the investors and not the bridge-lending banks.

But it remains to be seen if the banks will be able to find long term investors for the deals. Many of those deals were priced at a time when risk was seen as a hobgoblin of little minds. Today, with the true size of the risk goblin emerging, great thinkers are paying attention. The we'll-pay-you-back-when-we-feel-like-it bonds that financed leveraged buyouts six or twelve months ago will today be about as well-received by institutional investors as carriers of hemorrhagic fever. If the banks can't find outside investors, they themselves will have to become long term financiers of the leverage buyouts, often at disadvantageous terms. That means further potential for loss.

Unfortunately for the banks, the regulators can't issue statements encouraging the private equity firms to renegotiate their financing arrangements with the banks. Those arrangements greatly favor the private equity firms, and, the LBO boys didn't get yacht-buying rich by giving money away.

So the regulators are left to use whatever moral suasion they have to urge banks to be nice, but not overly nice, to distressed mortgage borrowers. What does that tell us?

On the level of the network news, it means that the regulators sound kind of warm and fuzzy. That's nice. And it's not exactly bad p.r.

But on a systemic level, we have an admission, implicitly, by the regulators that the derivatives markets have failed in their essential promise. Going back through the last 20 years, one sees the derivatives industry promoting its products with the claim that they would disperse risk and subdue volatility. Risk would be purchased by those that wanted to bear it, and those that didn't want it would be liberated from its onerous yoke. In particular, the major banks at the heart of the financial system would transfer away the risks that could cause a systemic failure, and safety and soundness would spread far and wide in the banking system. The financial markets would bask in the copacetic glow of a new and better world.

The problem was that the alchemy of derivatives didn't alter human nature. Presented with a path that apparently led to the Seven Cities of Cibola, investment bankers, hedge fund operators, and kindred souls worldwide plunged into the derivatives market, demanding vast quantities of risky financial instruments that they could purchase for their journeys to the kingdom of Croesus. These folks were too smart to believe that the business cycle had been repealed. But they managed to outsmart themselves into believing that the risk of the business cycle, as to them, could be traded away. Thus, they boldly bought risky investments that none had dared to invest in before, and in the process caused the creation much greater aggregate risk than otherwise would have existed. Stated otherwise, they engaged in speculative excess.

Speculative excess in the financial markets has a long and venerated history. Tulip bulbs in Holland, swamp land in Florida, silver futures, and earnings-free dotcom stocks are just a few of the better known examples. The darndest thing is that even though you'd think people would move up the learning curve after each pop of the bubble, progress remains painfully slow. We now have the derivatives bubble, where people thought that the magical qualities of derivatives contracts would make the business cycle go away, at least as to them. And they invested like anyone who thought they'd never face a downturn would invest. If the markets will always be friendly, at least as to oneself, there is logically no risk that isn't worth taking.

Unfortunately, the business cycle is the product of speculative excess, and human nature assures that speculative excess--and therefore the business cycle--will always be with us. There is no vaccine, no magic bullet. Any contract or investment that can be used to hedge or transfer risk can also be used for speculative purposes. Just flip it around and a prudent hedge becomes a wild gamble.

The regulators have assiduously avoided regulating derivatives, and now their only options are treating the symptoms with monetary policy, and moral suasion. The efficacy of both is uncertain. Preventative measures haven't appeared publicly on regulatory agendas. No individual player in the derivatives market has an incentive to seriously urge reform. From the perspective of any one market participant, it's easier to just trade away one's risk and the Devil take the hindmost. Of course, as we now know, the banks at the center of the financial system can't really trade away risk. But the private sector doesn't have the ability or incentives to assess and address systemic risk. The question at hand is whether anyone else will take up the mantle.

Health News: warning, popcorn fumes may be hazardous to your health. http://www.wtop.com/?nid=106&sid=1238504.