The spreading of systemic risk and the threat of the derivatives market

A recent unpublished paper by the Fed discussed the effect of direct channel contagion may have played on the 2008 global financial crisis. (Direct contagion is essentially direct and real financial linkages between various market participants or economies). This paper raises interesting issues about how the crisis spread from the U.S. subprime market to the rest of world in a relatively short amount of time.

First, there were a surprisingly high number of market participants in “developed” countries, such as Europe, engaging in the herd mentality when it came to foreign holdings of U.S. asset-backed securities (“ABS”). Based on the authors’ estimates of U.S. ABS held by foreign participant, Europe held nearly 50% (compared to China’s less than 2%). These estimates apply only to foreign holdings of ABS, and not U.S. participants with interests in these securities.

Second, many of these holdings were financed by dollar funding. Thus, then the U.S. ABS started turning toxic, these foreign market participants needed to rely on dollar funding to pay of their U.S. liabilities (i.e. the securities were based on the U.S. dollar and therefore any liabilities resulting from the fall in the assets’ values required payments in U.S. dollars). This problem was compounded by the over reliance on short-term funding. As the credit markets started to freeze many market participants could not get adequate dollar funding through the short-term market—that is the cost of borrowing over the short-term became extremely expensive. This in turn hurt other market participants who relied upon the short-term markets to run their businesses.

While these direct linkages—foreign exposure to toxic U.S. ABS and an overreliance on short-term funding—added to the crisis, the Fed paper finds that they were not sufficient, in and of themselves, to cause the full severity of the Great Recession. The paper then notes a non-definitive list of indirect linkages, including the lack of transparency in complex financial instruments, runs on firms that depended on the short-term markets, market-to-market accounting losses, and others. The authors suggest that the direct and indirect linkages have connected advance economies into a single market, as opposed to markets based on geographical location.

If this is true, and advance economies have truly formed a single, international market, then there still remain significant risks to this economy. As posted here, the 2008 market crisis exposed the risk resulting from credit default swaps (CDS). This market, however, was 14 times SMALLER then the current $500 trillion derivatives market. If an increase in interest rates, which are expected by the end of 2010, will wreak havoc in then derivatives market, then 2011 may contain the worst economic crisis ever!

This theory, however, is based on a market that is renowned for its lack of transparency. In other words, nobody really knows what is going on in the entire derivatives market—which is why governments should force the market onto public exchanges. My hunch is the Fed is likely aware of this danger and will wait for Congress to pass its financial overhaul bill before raising interest rates. If Congress requires derivatives to trade on public exchanges and demands that clearinghouses handle the trades, this may be enough to shrink the market and allow the Fed to slowly raise rates without major economic disruptions. Ultimately, the derivative beast may just be the monster that gets Congress to put aside political for one month and actually pass a bill that truly addresses systemic risk.