Is the War Against Systemic Risk Being Lost?

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

Comments

[pokernut]

excellent article. thanks for posting.

2009 Mar 08 11:09 AM

[ArkansasAngie]

How many dimensions can we control for? Housing prices. CDS’. Residential defaults. Unemployment. European banks. East European debt. Emerging market debt. Tax policy. Unfunded pension obligations. Entitlements. Iraq. Afghanistan. Etc., etc, etc.

This is the definition of uncertainty and the complex interwoven world we live in. Negative synergy -- the whole is bigger than the sum of its parts.

You are quite correct that systemic risk has to be addressed.

2009 Mar 08 11:13 AM

[Nik Kondratieff]

This is a great synopsis of the vast unknowns relative to the stimulus/Fed policies and their ability to stem the tide of systemic risk. Nobody has a clue, and the Geithner/Summers/Berna... plan is to just throw more money at the problem hoping it will save us from the contagion.

2009 Mar 08 11:17 AM

[Prudent Man CFA]

The "System" didn't fail the regulations put in place to prevent the failure has been ignored for over ten years.

The Free Enterprise System was taken over by greedy Capitalists (never met one that didn't want to own a monopoly) and power hungry, irresponsible politicians who should have been kicked out years ago by Congressional Term Limits.

Restore the Free Enterprise System, with the safeguard in place to keep it Free from monopolies and oligopolies, and our economy will grow and be self-correcting of excesses.

2009 Mar 08 12:13 PM

[sportsguy]

Well said, Prudent man, acquisitions should not be part of executive compensation, organic growth should only be rewarded. Glass Steagall should be brought back, and ETFs which control commodities futures should be made illegal. Community lending act needs to be managed by Freddie or Fannie, not the private sector. Minimum wage needs to be indexed to inflation as technology replaces human jobs, only the service sector will remain as the employer of last resort, until US wages fall far enough to offset the transportation costs from mfg overseas

2009 Mar 08 01:49 PM

[samwise]

excellent title--but "systemic collapse" has already occurred so you and apparently all of the commentariat are still behind the curve. In other words Citigroup, BofA, Merril Lynch, Bear Sterns, Geneal Motors, Chrysler and AIG have all now failed and are simply examples of "system failures." All of them are gone and they will never return. At present that has only cost the American economy 4.5 million jobs which is quite light considering all the "big talk" that all these folks who once lead these institutions were barking out over their histories. Bascially I agree with your premise that the government has in effect become a sabotuer in the name of "saving these institutions" albeit an unwitting one. Having said that you are now missing the mark when it comes to what FURTHER systems are now put at risk due to the total collapse of "the Plan" with the election of Barak Obama and the ascension of Democrats to their self-proclaimed "position of power." There are far more valuable sytems here now at risk now that the government has completely botched the "bailout." Think of it as the sabotuer heading towards the nuclear reactor in the submarine having just assassinated the executive officer. I will say this--at least you're in the game rhetorically. Still, to have value in this format you need to start giving people the obvious picture because soon the TV folks who are already on to this manifest incompetence will start "dialing it in."

2009 Mar 08 02:11 PM

[Mad Hedge Fund Trader]

The market says you are right. To say the market has gone mad is an understatement. The Dow has lost 24% since January 1, giving up $2.6 trillion in value. Other than that Mrs. Lincoln, how was the play? Credit default swap risk premiums now tell you that it is much riskier to invest in Warren Buffet’s Berkshire Hathaway (BRK/A) than Vietnam, and that Russia is a safer bet than General Electric (GE). The Dow is headed for the 4,000, according to ultra bear Felix Zulauf of Zulauf Asset Management in Zug, Switzerland. The rock star fund manager believes that we entered a 10-15 year bear market in 2000. He argues that analysts are smoking something with S&P consensus earnings forecasts at $60, down from $100 a year ago, and that the real number will come in at zero to $40. We may see one more bear market rally to 9,000 in the next few months led by financials, mining stocks, and consumer discretionaries. After that the Dow will drop by half. Day traders only need apply.

2009 Mar 08 04:49 PM

[CJJ]

What a bunch of whiners you all are. Nothing is good, it is all bad. Wah.

Basically this is a global issue. Everyone is in everyone's pocket. Everyone is out for #1. By acting in their own interests when there is really only 1 global interest is going to lead to doom.

Maybe you whiners should stop whining and be part of the solution not part of the problem.

2009 Mar 08 05:32 PM

[the ilster]

Systemic Risk is very much on the table right now. IE plunging equity prices. The CDS spreads regarding BRK and GE is ample evidence. A chain reaction of debt defaults is immanent. If you cant see the time bomb of Defaults coming in 2009 that will crater the financial system you are BLIND. If we make it to the summer I will surprised.

People need to understand the financial system is permanently DAMAGED! Its being allowed to slowly implode by the masters of the universe THE FEDERAL RESERVE. You still have time to sell stocks and get short and make money here. Don't be a fool! This is black and white. Depression and Deflation are better than 75% chance. While I am an eternal optimist the facts speak so loudly that I have to be a realist. were toast! For more in depth analysis go to chrismartenson.com and watch the Crash course. It will enlighten you and give you confidence to stay short the market. positions QID AMZN IYR all shorts and 1 long RJI commodities index

2009 Mar 08 07:13 PM

[@TexasER]

I agree with samwise that the system has already failed.

The real risk is that everyone will realize this at one time and trigger a panic induced inflation event. And not because the "printing presses" are running. But because trillions USD sitting in money markets starts suddenly chasing a limited supply of physical assets.

Treasury/Fed knows this and is doing a great job when you look at it that way.

So far so good.

2009 Mar 08 11:58 PM

[kelm]

The system is structurally damaged, probably permanently meaning that it will have to be changed substantively before it works again and it will never be the way it was. Outright failure is still ahead of us and we are in fact increasing the systemic risk to the US economy and US dollar by our deficit spending. We have not yet seen the waves of sovereign debt defaults and corporate bond defaults that are ahead of us. The US dollar has had a rally in recent months on the fantasy of "flight to quality" but that has been a perceived lesser of evils and is unsustainable. Wait a few weeks until T-bonds start un-raveling ad the dollar drops and we will start getting a glimpse of what is coming.

2009 Mar 09 11:12 AM

[henarl]

Diogenes was right. There are no honest men and there is no lantern bright enough to illuminate the extent of financial systemic risk. Humanity will survive but there will be many more trillions lost before this is over.

2009 Mar 09 01:25 PM

[carey_jim]

None of us is truly a libertarian or anarchist, even though many of like the idea. Libertarianism is an impotent reaction against the excessive powers of the government/oligarchy.

Without regulations and strictly enforced rules, cheating predominates over fair play and the most unscrupulous, 'dirty' players too often defeat the best players.

America was born in the early 1600's, as totalitarian society under the control of king James I and under the strict Puritan rule of John Wintrop and others.

From the very beginning, however, under the influence of the immense distance from England and Europe which was the Atlantic ocean, and with the examples of many different ways of life which were represented by hundreds of native cultures and of many African and European cultures, America began to develop a unique sense of individual freedom and freedom from centralized authority.

Our fathers, the British, also underwent a bloody revolution in the 17th century, which, even if it ultimately failed, led to more individual freedom for them and a less centralized control. This revolution and the Enlightenment which followed were important factors leading to the American Revolution.

After more than two hundred years, America has moved away from the values of its Revolution and has moved closer to its early totalitarian origins under James I and John Winthrop.

History shows that when ruling class/governments reach extremes of inequality, inherited privilege and corruption, they provoke wars, economic collapse and revolution.

Asking Washington regulators to 'keep System Risk in check' is an example of economic simplification that I have already warned you against.

Our problems are far more complicated. Geographic, economic, social, psychological, cultural and historical forces, that we can't hope to completely understand, will be more influential than simple economic forces.

Denying and misunderstanding these forces will bring wars and revolutions instead of reforms and change.

2009 Mar 09 03:07 PM