At the end of the day, no stimulus plans, regardless of size or direction, will have any sustainable impact if Washington regulators are unable to keep systemic risks in check. Clearly, leaders in Congress are hoping that the trillions of dollars of rescues and bailouts will stem the slide in joblessness, home prices and consumer demand. But even assuming that there are signs that the Obama Administration’s vision of an economic recovery is starting to turn into a reality later this year, the pace of rising systemic risks may well create conditions akin to a major depression and an unprecedented meltdown in equity prices.
Last March, the decision by Fed and Treasury officials to save Bear Stearns was triggered by the imminent crisis in the $2.5 trillion repurchase (or “repo”) market in which banks raise cash from mutual funds, hedge funds, insurance companies and even central banks by posting collateral; the overwhelming proportion of repo contracts are rolled over on a daily basis. Initially, Ben Bernanke and Timothy Geithner (the Fed’s point man on Wall Street at that time) were ready to let Bear fail. “Bear is not one of the bigger firms,” a senior Fed official said at a closed-door meeting which was attended by then Treasury Secretary Hank Paulson. “It does not present any systemic risk.” But the report from those checking Bear’s books painted an entirely different scenario.
With each passing hour, an increasing number of Bear’s lenders were requesting the termination of their repo agreements, reminding regulators of the run by depositors on the Bailey Bros. Building & Loan in “It’s a Wonderful Life.” Bear’s institutional counterparts in the credit default swap market, numbering a staggering 5,000-plus, were in a state of panic. “It was all about counterparty risk at that point, so we had to do whatever it took to keep the system intact,” a British central banker was told by a JP Morgan Chase (JPM) director many months later. JP Morgan ended up buying Bear Stearns at what was then considered a knockdown price.
Noticeably, in line with Chairman Bernanke’s finger-in-the-dyke answer to systemic risk, the true nature of the problem was never recognized, let alone addressed. One insider involved in the Bear rescue said that the sheer range of counterparties presented a challenge too formidable to take on in a climate where asset values were rapidly deteriorating across the business matrix, domestically and internationally. Another researcher assisting Timothy Geithner disclosed that, the phenomenal exposure to traditional derivatives (currency swaps, interest rates swaps, structured notes, index options and far-forward FX contracts) was never taken into account when pricing Bear’s shares. More specifically, no effort was made to either quantify or control two critical elements of systemic risk, i.e. risks pertaining to counterparty performance and risks governing fair value asset measurements. Though the latter is now being scrutinized to some degree under the “stress test” formula, any discussion of the former remains a no-no in regulatory circles.
Has all the recent economic data (including Line U-6 of Table A-12 in the February employment report and the SGS Alternative) now magnified those risks? And will the acceleration of those risks far outstrip the pace of the remedies which the Obama Administration is currently ready to implement? Of course, trying to get hold of one person in Washington who can or will identify, and quantify, the level of systemic risk in the US financial system today is like Diogenes (the Cynic) searching for an honest man in Ancient Greece. But the series of Wall Street analysts advocating long-term positioning today are either trying to keep their jobs (and funds under management) or are blissfully unaware of the fact that counterparty risk to domestic financial institutions is not simply the result of domestic mortgage and asset securitizations; perhaps a greater element of counterparty risk comes from counterparties outside America. By one considered estimate, at least 20% of such risk emanates from the emerging markets.
In view of the government’s intervention in the housing and consumer-credit markets, this writer was prepared to temporarily abandon his decisive short bias and to trade the equity indices (DIA, EEM, QQQQ, SPY, XLF) from both sides. But information received overnight from a few developing countries now suggests that hundreds of exporters, importers and manufacturers are quite prepared, with tacit government consent, to default on “unprofitable” derivative contracts. The Indian rupee’s fall to 51.70 (per US$), for example, prompted a major Mumbai-based industrial group, listed as a significant player in the infrastructure sector, to question the validity of sizable far-forward FX contracts with at least four international banks yesterday.
Finally, one key characteristic of embedded systemic risk is that it can cause an implosion in one or other bank balance sheet at short notice. Therefore, the recommendation is to sell on rallies, and to react only to sharp rallies (10-15%) from Friday’s closing levels if one prefers a relatively modest risk-reward profile. Otherwise, the best trade is no trade at all.
Disclosure: no positions