Mover Mike

From the WSJ, GM Debt Poses Challenge To Derivatives Market

The car maker has about $30 billion in debt. Traders estimate more than $200 billion in credit derivatives are linked to GM. But because such derivatives don't trade on an exchange, nobody knows for certain how much credit-default swap protection has actually been written on GM. And nobody can say with confidence that they even know who is on the other side of the trades that they have entered into.

[...]

Four years ago, the derivatives market was a fraction of the size of the underlying corporate-bond market. Today, it is estimated at $12.5 trillion, more than twice the underlying market's size, and it continues to expand rapidly.

A report in 2002 from the Financial Policy Forum has a different number for the size of the derivative market.

Today the size of derivatives markets is estimated by the Bank of International Settlements to exceed $109 trillion in outstanding contracts and over $400 trillion in trading volume on derivatives exchanges.

Are you familiar with E. Gerald Corrigan, an executive with Goldman Sachs Group Inc.? Mr. Corrigan heads the Counterparty Risk Management Policy Group II, an industry group focused on the derivatives market.

Mr. Corrigan is organizing a symposium on March 1 to follow up on issues raised in a report published by the Counterparty Risk Management Policy Group II last July.

You can read the full report here.

The report is directed at initiatives that will further reduce the risks of systemic financial shocks and limit their damage when, rarely, but inevitably such shocks occur. (emphasis added)

There are three elements to a financial shock and these three elements don't happen sequentially but all at the same time.

First, the triggering event or events cause sharp and sudden declines in one or more classes of asset prices. The decline in asset prices is sufficiently steep to raise questions about the creditworthiness of major counterparties or institutions such that the analytical distinction between market risk and credit risk blurs as market risk and credit risk feed on each other.

Second, the combination of falling asset prices and the erosion of creditworthiness causes market participants to commence risk mitigation efforts such as position liquidations which - while perfectly reasonable at the micro level - add to macro pressures on asset prices wjich in turn trigger the initial evaporation of market liquidity for one or more classes of assets. The evaporation of asset liquidity aggravates both market and credit risk and begins to call into question balance sheet liquidity for some institutions. Investor position liquidations intensify these pressures.

Third, in these circumstances, once seemingly generous amounts of margin or collateral are rapidly called into question, thereby dramatically elevating credit concerns. The escalation of credit concerns further influences the defensive behavior of financial market participants, all of which acts to reinforce the cumulating the adverse market dynamics. Hence a financial crisis with systemic risks is at hand.

After a list of ten fundamentals about financial shocks and derivatives the Report makes a chilling point:

A central and recurring theme to every aspect of this Report is, in a word, complexity.

There are whole libraries devoted to identifying and managing risk in complex systems, but there is no accounting for the long tail effect. The shock that happens that is identified as having very little risk on a bell curve of risks. One doesn't need a bell curve to assess the risk of a financial shock.

Let us recall Fed Chairman Bernanke's comment yesterday in November, 2005 at the Hearing Regarding Ben Bernanke's Nomination to Be Chairman of the Board of Governors of the Federal Reserve in response to Sen. Sarbanes concerns about derivatives.

Bernanke:Nevertheless, broadly speaking, my understanding is that the hedge fund industry has become more sophisticated, more diverse, less leveraged and more flexible in the years since LTCM.

GM Derivatives Bernanke Sarbanes Mover Mike

Update: as to when the meeting between Sen Sarbanes and Bernanke took place.

Jim Sinclair of JS MineSet recommends substituting "over the counter derivatives" for "swaps" in the following article from Bloomberg.

Banks Plan to Settle Default Swaps (over the counter derivatives) in Cash, Avoiding `Squeeze'

Feb. 17 (Bloomberg) -- Debt-insurance contracts may be settled in cash, averting a rush for bonds when companies default, under a plan being proposed today by the International Swaps (over the counter derivatives) and Derivatives Association.

The market for credit derivatives, dominated by credit- default swaps (over the counter derivatives), expanded fivefold in two years to about $12.4 trillion, according to ISDA in New York. Banks sold so many of the contracts that when auto-parts maker Delphi Corp. defaulted in October, there weren't enough bonds to settle with, causing prices for the notes to rally.

[...]

No one knows just how much debt is insured through credit- default swaps (over the counter derivatives) because the contracts are privately arranged and aren't listed on any exchange.

Credit derivatives are the fastest growing part of the $270 trillion market for derivatives, financial obligations based on interest rates, the outcome of certain events, or the price of underlying assets such as bonds.

Investors use credit-default swaps (over the counter derivatives) to protect against non- payment on debt, or trade them as a way of betting on a company's credit quality. The buyer of the contract pays an annual fee and receives the full amount insured if the borrower defaults. Usually the buyer is obliged to deliver the defaulted loans or bonds as part of the settlement process.

Why is cash settlement important? In the case of the Saudis who bought silver through the British and then demanded the physical, they were told it wasn't available. Apparently, the British leased it out. If you were the Saudis would you want cash or your silver?

Those who have followed GATA, believe that the central banks and the bullion banks are short 12,000 to 16,000 tins of gold. When it becomes crunch time, do you want some fiat currency or do you want your gold? The Comex and the government will try, maybe even mandate, you settle in cash. To settle in gold would drive the price to the moon.

The new piece of information in this article is the size of the derivatives market: $270 Trillion. The BIS in 2002 estimated the size to be $109 Trillion. That is almost triple in three years!

Swaps Over the Counter Derivatives Finance

Carnival of the Capitalists is up and there is an interesting article by James Hamilton at Econbrowser entitled Oil at $15-30 a barrel?. In the energy chapter of the Economic Report of the President there is this statement:

Although oil prices have risen to more than $60 a barrel in recent months, they have averaged as low as $25 per barrel within the last five years. Having experienced past volatility in oil prices, oil companies report using a working assumption of $15-$30 per barrel for the future price of oil when making long-term investment planning decisions. (emphasis added)

Hamilton uses a variety of finance techniques to investigate the possibility of returning to prices of $15 to $30 a barrel.

What struck me about the chart he shows of oil prices in 2005 dollars, is how remarkably stable oil prices were in the period from 1986 to 2004.

Energy Bulletin has an article entitled The End of the Oil Standard and there's this paragraph:

According to Pennwell's Energy Statistics Sourcebook, OPEC production declined from 30.67 million barrels per day in 1979 to 16.02 million barrels per day in 1985. The same source list OPEC's maximum sustainable production capacity as 34.4 million barrels per day in 1985. By the end of 1985, OPEC had 18 million barrels per day of shut-in oil production capacity. It became clear that there had to be a price ceiling as well as a floor. This was the price band.

Now Energy Bulletin's final paragraph:

Was the oil standard an accident or was it a deliberate product of U.S. policy? Motives are difficult to determine and the U.S. Treasury has not claimed to tie the dollar to oil prices. The ultimate effect of the end of the oil standard is difficult to predict, but one should not understate its importance.

Many have written that the world was on an "Oil Standard" and for the period of 1985 to 2004 you could exchange your dollars for an average $30 barrel of oil. Then something changed and oil broke out of that range to over $60 today. Imagine if you are OPEC. You suddenly lost half of the value of your dollar denominated assets in a year. (You can say oil went up to $60 or you can say the dollar only bought half as much.)

We can look back at the changes that took place in this country, financially, since 1971 when Nixon took us off the "Gold Standard". The Energy Bulletin alludes to serious changes coming from the end of the "Oil Standard".

Back to Econbrowser, Hamilton asks the question:

...if ($15-30) is the downside risk that oil companies are contemplating, why don't they hedge away the risk by selling more oil forward at the $64/barrel price that one can currently guarantee through the December 2010 futures contract?

That's is exactly what Barrick (ABX) and Placer Dome (PDG) did when gold prices were in a 20 year bear market. With the collusion of the central banks and the bullion banks, these gold mining companies and others as well, sold futures on gold, ostensibly, to take away the mining risk, but it also kept the use of gold, as an inflationary signal, under wraps. The politicians didn't want you to know that the dollar was losing 95% of its value. Now we have Barrick with losses on its hedges north of $3 Billion and Placer Dome with losses on its hedges of $1.5 Billion. Pray the oil companies don't get this stupid!

Carnival of the Capitalists energy gold standard oil standard derivatives

From the London Irvine Report today, Financial Tools Outpacing Controls, Geithner Cautions

Timothy F. Geithner, president of the Fed Bank of New York warned yesterday that the U.S. financial system is evolving faster than the ability of investors, lenders and regulators to evaluate and manage the risks involved.

The rapid growth in complex new investment instruments and recent changes in market structure have helped make the nation's financial system more flexible and resilient...But, "there are aspects of the latest changes in financial innovation that could increase systemic risk" -- the danger that the losses of a few investors could set off a chain reaction of events that disrupts the broader financial system, as did the near-collapse of a heavily leveraged hedge fund in 1998.

Another Fed official warns of systemic risks. London Irvine says

My suspicion is that the Fed’s policy wonks, nerds and internal models, know economic bird flu’s coming, and that very little works to reverse it. Funny money loses its fun. Better get out front and say we warned about it but no one listened. Not my fault but yours. Still, better get a tape of someone telling the President. Stay long precious metals, there’s a funny smell coming from Denmark.

Only one other blogger has commented on the warning from Geithner, Vigilant Investor | Ernharth Perspective. For most of the US it's What Me Worry!

Timothy F. Geithner derivativesfinance