Derivatives Still a Huge Risk - I Was Right After All

Many regulators and people in the industry itself argue that the decidedly lopsided concentration of derivatives is not as bad as it looks. The largest commercial banking groups typically have the most sophisticated risk management systems and access to resources and counterparties that might not be available to smaller peers. Soothsayers also contend that the gross notional exposure exaggerates the risks, because a significant volume of transactions are interest rate swaps, for example.

So-called “netting” agreements minimize the dangers even further. Under this arrangement, when banks have multiple contracts outstanding with the same counterparty, they agree to tally the total value of what they owe versus what they are due, calculated in present value terms, to arrive at a net exposure, which is typically far smaller than the gross amount. Even on this basis, the overall derivatives-related net credit risk exceeded $1 trillion in the commercial banking sector at the end of 2005.

But that doesn’t include unforeseen circumstances that might lead to differences of opinion, liquidity issues, or torrents of litigation about the value of individual agreements. Nor does it consider the possibility that if one bank gets into trouble, others will be less than cooperative as they face major problems of their own. And even if the banks come to an arrangement among themselves, it will not necessarily address the potential fallout from their exposure to counterparties such as the GSEs, hedge funds, securities fi rms, and fi nance arms of large multinational corporations. Hedge funds, for example, accounted for 55 percent of credit derivatives trading in the year through March 2006, according to Greenwich Associates.

While these concerns will only become more critical when the economic situation takes a turn for the worse, the real dangers are likely to stem from seriously fl awed assumptions and conflicts of interest. Despite the involvement of Wall Street’s best and brightest— academics, rocket scientists, and programmers—and the sense of mathematical certitude conveyed through the use of complex calculations and high-powered computers, pricing derivatives involves a significant amount of guesswork that is not necessarily unbiased. Often, expectations are drawn from historical patterns that, for many newfangled varieties, are woefully incomplete. Or they are based on how other securities are trading, without taking into account differences that gain importance under stressful market conditions.

--From Chapter 4, "Derivatives," Financial Armageddon

After my book was published in the spring of 2007, I can remember so-called experts and clueless bloggers arguing that fears about derivatives were overblown, and that doom-and-gloomers like me didn't really understand "basic" concepts like notional value and netting arrangements.

Under the circumstances, I admit to thinking "I told you so" when I read the following article, "Derivatives Still Pose Huge Risk, Says BIS," by The Telegraph's Ambrose Evans-Pritchard, in which those-in-the-know acknowledge that gross exposure, among other things, really does matter after all:

The global market for derivatives rebounded to $426 trillion in the second quarter as risk appetite returned, but the system remains unstable and prone to crises, according to the Bank for International Settlements (BIS).

The BIS said in its quarterly report that total turnover of derivatives rose 16pc, mostly due to a surge in futures and options contracts on three-month interest rates.

Stephen Cecchetti, the bank's chief economist, said over-the-counter markets for derivatives are still opaque and pose "major systemic risks" for the financial system. The danger is that regulators will again fail to see that big institutions have taken far more exposure than they can handle in shock conditions, repeating the errors that allowed the giant US insurer AIG to write nearly "half a trillion dollars" of unhedged insurance through credit default swaps.

Comments

[Tom Armistead]

You were right, and you're still right.

Every quarter that regulatory powerhouse, the OCC, puts out a summary of the derivatives positions of the big banks. Every quarter, every bank shows derivative assets well in excess of derivative liabilities. I am a naive soul, and suffer from the belief that the big banks are betting against each other, and that each derivative asset corresponds to a derivative liablity on the books of another bank. Under the cirmcstances, for the whole system comprising the big banks, the derivative assets should equal the liabilities. They do not.

The only way this zero sum Ponzi scheme adds up is to vote somebody off the island and declare all his bets losers. That was Lehman. Otherwise, to make it add up you have to suck in taxpayer money. We've already had one round of that.

2009 Sep 15 05:54 AM

[VALUEDIV]

Thank you for speaking out on the unspeakable. The government and financial institutions ignore their vulnerability to derivatives with nigh a mention in the press. This will come home to roost. Liquidity is a very misunderstood term by the American public- it is a vague notion of having assets that can be sold on an open market.

The big financial institutions may be feeling their oats, but their lifeblood is in the millions on workers who produce goods and food and have to borrow and pay interest in mortgages or businesses. Their circulatory system to distribute funds are the Regional Banks who are closest to the borrowers and they are failing in record numbers (90 last week alone). When the lack of a complete financial pyramid becomes clear, the Big Boys will fail again.

That is when the Derivatives as in Bear Sterns and Lehman Brothers (RIP) will be called in. Where is there circa $500 Trillion of Liquid Assets to back these? It does not exist!
Buffett said it. Soros said it. You said it. But, who's listening- they really don't want to hear that the Monster Bubble is the Derivatives global float ready to be called in.

Keep up the crusade. I have been writing to WSJ, Forbes, Fortune, ad nauseum about the danger of Derivatives for four years. I never got a single acknowledgement. Forbes did publish a "feeble" article, but that is the response. If we repeat this mantra enough, maybe someone will hear before the imminent and certain derivatives bubble.
Best Regards from Another Voice In The Desert

2009 Sep 15 02:31 PM