Bloomberg news: Bond Market Will Never Be the Same After Goldman: Michael Lewis

This is a sarcastically funny shout-out to Goldman Sachs: Bond Market Will Never Be the Same After Goldman: Michael Lewis available at  http://www.bloomberg.com/apps/news?pid=email_en&sid=aWUolZvh4qmE

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A recent unpublished paper by the Fed discussed the effect of direct channel contagion may have played on the 2008 global financial crisis.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.

World Faces Serious New Economic Challenges

Here is yesterday's IMF post regarding its current outlook for the global economy.

 

 

Sent to you by Bo Howell via Google Reader:

 

 

World Faces Serious New Economic Challenges

via iMFdirect - The IMF Blog by iMFdirect on 4/21/10

By Olivier J. Blanchard 

Let me begin with some good news. The global recovery has evolved better than expected.  We at the IMF now forecast global growth to reach 4.2% in 2010, an upward revision of 0.3% from our  January forecast, and 4.3% in 2011. Alongside growth, global trade has also shown a strong rebound, and so have capital flows.  And, as discussed in the newly released Global Financial Stability Report, financial market conditions and stability have improved.

These good global numbers hide however a more complex reality, namely a tepid recovery in many advanced economies, and a much stronger one in most emerging and developing economies.

Let me discuss each group in turn.   

We forecast growth in advanced economies to be 2.3% for 2010 and 2.4% in 2011.   This is just not enough to make up for the ground lost during the recession.  Output for these countries is now 7% below its pre-crisis trend, and this "output gap" is expected to remain large for many years to come.  Associated with this prolonged output gap is persistent high unemployment.  We forecast the unemployment rate in advanced economies to reach 8.4% in 2010, and to only decline to 8.0% in 2011.  

The main factor behind this weak performance and this prolonged output gap is weak private demand.  In the United States, consumers, who were the drivers of the economy before the crisis, are being more prudent.   In Europe, where banks play a central role in financial intermediation, the weak banking sector limits credit supply.   In Japan, deflation has reappeared, leading to higher real interest rates, and putting in danger an already weak recovery.

By contrast, we forecast growth in emerging and developing economies to be much stronger, 6.3% in 2010, and 6.4% in 2011.   Developing Asia is in the lead, with forecasts of 8.7% for 2010, and 8.6% in 2011.   Growth appears not only strong but sustainable.   While fiscal policy often played a central role in supporting activity in 2009, private demand is strengthening, and can sustain growth in the future. 

Serious new challenges

 The asymmetric nature of the recovery creates serious challenges, both for advanced and for developing and emerging market economies. 

In advanced countries, the main challenge is fiscal consolidation.  A year ago, the risk was that private demand would collapse, leading to another Great Depression scenario.  The priority was thus to implement fiscal stimulus programs, and avoid this catastrophic scenario. This we did.  

Thanks in part to the stimulus programs, demand did not collapse, and has indeed started to grow again, if only weakly.  One year later however, the risk has shifted location.   The loss in fiscal revenues associated with the loss in output is threatening to lead, if not contained, to a debt explosion.   In most countries, fiscal consolidation must increasingly be the priority.  

Emerging and developing countries face a different set of challenges.   One of them is large capital inflows.   Higher growth prospects and higher interest rates are attracting large capital inflows.   Such inflows, especially when driven by growth prospects, are fundamentally good news, but we have learned from experience that they can also lead to booms and busts.  Thus, the main policy issue facing recipient countries is how to best accommodate these flows, how much to let the currency appreciate, how to use macroeconomic policy, how to use macro-prudential tools, reserves, and capital controls, to best avoid excesses and maintain stable growth. 

Solutions closely linked

Interestingly, and importantly, the solutions to the challenges facing advanced and emerging countries are closely linked:  

In advanced economies, fiscal consolidation is needed, but is likely to have an adverse effect on demand and thus on growth.   To offset these adverse effects and maintain growth, advanced countries, as a whole, may need to depreciate their currency so as to increase their net exports.  

 This, in turn, implies that emerging and developing countries, again as a whole, do the reverse, namely let their currency appreciate, and reduce net exports.  It is in their global interest to do so, as this adjustment may be needed to sustain growth in advanced countries, and, by implication, strong growth in the rest of the world.   In many countries, it is also clearly in their own, direct, interest to do so. 

In China for example, a shift away from exports towards domestic consumption—a shift that requires both structural measures to decrease saving, and an appreciation of the currency—appears highly desirable. 

New stage of the crisis

To conclude, we find ourselves at an important new stage of the crisis. A global depression has been averted. The world economy is recovering, and recovering better than we had previously thought likely. This is certainly welcome news. 

But new—and no less formidable—challenges have presented themselves. Achieving strong, sustained and balanced growth will not be easy.  It will require more work—namely fiscal consolidation in advanced countries, exchange rate adjustments, a rebalancing of demand across the world.

These are the tasks facing policymakers over the next few years.

 

 

Things you can do from here:

• Subscribe to iMFdirect - The IMF Blog using Google Reader
• Get started using Google Reader to easily keep up with all your favorite sites

 

 

Are Interest Rate Derivatives a Ticking Time Bomb?

This is a very interesting, albeit lenghty and complicated, post about the derivatives market and the risks it still poses to the global economy.

 

 

Sent to you by Bo Howell via Google Reader:

 

 

Are Interest Rate Derivatives a Ticking Time Bomb?

via Washington's Blog by George Washington on 4/21/10

Derivatives are the world's largest market, dwarfing the size of the bond market and world's real economy.

The derivatives market is currently at around $600 trillion or so (in nominal value).

In contrast, the size of the worldwide bond market (total debt outstanding) as of 2009 was an estimated $82.2 trillion.

And the CIA Fact Book puts the world economy at $58.07 trillion in 2009 (at official exchange rates).

Interest rate derivatives, in turn, are by far the most popular type of derivative.

As Wikipedia notes:

The interest rate derivatives market is the largest derivatives market in the world. The Bank for International Settlements estimates that the notional amount outstanding in June 2009 were US$437 trillion for OTC interest rate contracts, and US$342 trillion for OTC interest rate swaps. According to the International Swaps and Derivatives Association, 80% of the world's top 500 companies as of April 2003 used interest rate derivatives to control their cashflows.

So interest rate derivatives are the world's largest market.

The largest interest rate derivatives sellers include Barclays, Deutsche Bank, Goldman and JP Morgan. While the CDS market is dominated by American banks, the interest rate derivatives market is more international.

In comparison to the almost $500 trillion in interest rate derivatives, BIS estimates that there were "only" $36 trillion in credit default swaps as of June 2009. Credit default swaps were largely responsible for bringing down Bear Stearns, AIG (and see this), WaMu and other mammoth corporations.

Where's the Danger?

In 2003, John Hussman wrote:

What is not so obvious is the extent to which the U.S. economy and financial markets are betting on the continuation of unusually low short-term interest rates and a steep yield curve. This doesn't necessarily resolve into immediate risks, but it could profoundly affect the path that the economy and financial markets take during the next few years, by making the unwinding of debt much more abrupt.

In response to very low short-term interest rates, many U.S. corporations have swapped their long-term (fixed interest rate) debt into short-term (floating interest rate) debt, to the extent that an increase in short-term rates could substantially raise default risks. Similarly, a growing proportion of homeowners have refinanced their mortgages into adjustable rate structures that are also sensitive to higher short-term yields. Finally, profitability in the banking system is unusually dependent on a steep yield curve, with a widening net interest margin (the difference between long-term rates banks charge borrowers and the lower short-term rates they pay depositors) ...

***

According Bank for International Settlements, the U.S. interest rate swap market [has] nearly doubled in size in the past two years. The reason this figure is so enormous is that there are usually several links in the chain from borrower to investor. A risky borrower may enter a swap with bank A, which then takes an offsetting swap position with bank B (earning a bit of the credit spread as its compensation), and so on, with a cheerful money market investor at the end of the chain holding a safe, government backed security, oblivious to the chain of counterparty risk in between.

Aside from the risk that any particular link in this chain might be weak (know thy counterparty), the U.S. financial system has gone one step further. In order to hedge against the risk of defaults, banks frequently lay credit risk off by entering "credit default swaps" with other banks or insurance companies. These swaps essentially act as insurance policies for credit risk.

***

In short, the U.S. financial system is in a delicate balance. On the issuer side, a great many borrowers have linked their debt obligations to short-term interest rates. This is tolerated by the financial system because the debt has been swapped out through financial intermediaries, so investors get to hold relatively safe instruments like bank deposits and Fannie Mae securities. This mountain of debt in the U.S. financial system - tied to short-term interest rates - is ultimately and perhaps somewhat inadvertently backed by the U.S. government.

On the investor side, Asian governments intent on holding their currencies down relative to the U.S. dollar have purchased a great deal of U.S. government and agency debt – effectively "buying dollars." ... A reduction of demand for U.S. short-term debt, either by foreign governments (particularly in the event that Asian governments decide to revalue their currencies) or by U.S. investors, could have very undesirable consequences.

All of which is why the U.S. is now extremely dependent on short-term interest rates remaining low indefinitely.

In March 2009, Martin Weiss wrote:

Until the third quarter of last year, the banks' losses in derivatives were almost entirely confined to credit default swaps — bets on failing companies and sinking investments.

But credit default swaps are actually a much smaller sector, representing only 7.8 percent of the total derivatives market.

***

Thus, considering their far larger volume, any threat to interest rate derivatives could be far more serious than anything we've seen so far.

And Monday, Jerome Corsi argued that cities, states and universities might be wiped out by changes in interest rates:

As interest rates begin to rise worldwide, losses in derivatives may end up bankrupting a wide range of institutions, including municipalities, state governments, major insurance companies

, top investment houses, commercial banks and universities.

Defaults now beginning to occur in a number of European cities prefigure what may end up being the largest financial bubble ever to burst – a bubble that today amounts to more than $600 trillion.

***

A popular form of derivative contracts was developed to permit one money manager to "swap" a stream of variable interest payments with another money manager for a stream of fixed interest payments.

The idea was to use derivative bets on interest rates to "hedge" or balance off the risks taken on interest-rate investments owned in the underlying portfolio.

If an institutional investment manager held $100 million in fixed-rate bonds, for example, to hedge the risk, should interest rates rise or fall in a manner different than projections, a purchase of a $100 million variable interest rate derivative could be constructed to cover the risk.

Whichever way interest rates went, one side to the swap might win and the other might lose.

The money manager losing the bet could expect to get paid on the derivative to compensate for some or all of the losses.

In the strong stock and mortgage markets experienced beginning in the historically low 1-percent interest rate environments of 2003 through 2004, the number of hedge funds soared, just as the volume of derivative contracts soared from a mere $300 trillion in 2005 to the more than $600 trillion today.

Unsophisticated Entities Getting Taken by Interest Rate Derivatives Salesmen

In 2008, Bloomberg pointed out that the SEC was investigating shady interest rate derivatives sales by JP Morgan and Morgan Stanley to school districts.

In 2009, New York Times writer Floyd Norris noted:

On the front page of The Times today, Don van Natta Jr. has a good article about the woes of little towns and counties in Tennessee that bought interest-rate derivatives sold by Morgan Keegan, an investment bank based in Memphis.

It turns out that these municipalities did not understand the risks they were taking. The derivatives have now blown up, and the officials are blaming the bank.

Matt Taibbi also recently noted that JP Morgan used interest rate swaps to decimate a small Alabama town:

The initial estimate for this project was $250 million. They ended up spending about $3 billion on this. And they ended up owing about $5 billion in the end, after you look at all the refinancing and the interest rate swaps and everything.

As the Bloomberg, Times and Taibbi stories hint, many unsophisticated schools, cities, states and universities were played by the big interest rate derivatives sellers, just as many people were played by the CDS sellers. So the fallout will likely be substantial.

But Aren't Interest Rate Derivatives Straightforward and Useful?

You might assume that interest rate derivatives appear to have a much more straightforward, legitimate business purpose than credit default swaps.

Yes, maybe. But the people thought the credit default swap salespeople and their bosses didn't really didn't understand them.

And as George Soros pointed out in 1994, the excessive use of dynamic hedging can and often does backfire:

I must state at the outset that I am in fundamental disagreement with the prevailing wisdom. The generally accepted theory is that financial markets tend toward equilibrium and, on the whole, discount the future correctly. I operate using a different theory, according to which financial markets cannot possibly discount the future correctly because they do not merely discount the future; they help to shape it. In certain circumstances, financial markets can affect the so-called fundamentals which they are supposed to reflect. When that happens, markets enter into a state of dynamic disequilibrium and behave quite differently from what would be considered normal by the theory of efficient markets. Such boom/bust sequences do not arise very often, but when they do they can be very disruptive, exactly because they affect the fundamentals of the economy…

The trouble with derivative instruments is that those who issue them usually protect themselves against losses by engaging in so-called delta, or dynamic, hedging. Dynamic hedging means, in effect, that if the market moves against the issuer, the issuer is forced to move in the same direction as the market, and thereby amplify the initial price disturbance. As long as price changes are continuous, no great harm is done, except perhaps to create higher volatility, which in turn increases the demand for derivatives instruments. But if there is an overwhelming amount of dynamic hedging done in the same direction, price movements may become discontinuous. This raises the specter of financial dislocation. Those who need to engage in dynamic hedging, but cannot execute their orders, may suffer catastrophic losses.

This is what happened in the stock market crash of 1987. The main culprit was the excessive use of portfolio insurance. Portfolio insurance was nothing but a method of dynamic hedging. The authorities have since introduced regulations, so-called 'circuit breakers', which render portfolio insurance impractical, but other instruments which rely on dynamic hedging have mushroomed. They play a much bigger role in the interest rate market than in the stock market, and it is the role in the interest rate market which has been most turbulent in recent weeks.

Dynamic hedging has the effect of transferring risk from customers to the market makers and when market makers all want to delta hedge in the same direction at the same time, there are no takers on the other side and the market breaks down.

The explosive growth in derivative instruments holds other dangers. There are so many of them, and some of them are so esoteric, that the risks involved may not be properly understood even by the most sophisticated of investors. Some of these instruments appear to be specifically designed to enable institutional investors to take gambles which they would otherwise not be permitted to take ....

Doug Noland wrote an intriguing article in 2001 - based on the research of Bruce Jacobs (doctorate in finance from Wharton, co-founder of Jacobs and Levy Equity Management) on portfolio insurance - arguing that interest rate derivatives were widely being used without understanding the risks they create for the system (warning: this is long ... go get some caffeine, sugar, nicotine or exercise, and then come back and keep reading):

I would like to suggest moving Bruce Jacobs' excellent book, Capital Ideas and Market Realities to the top of reading lists. From the forward by Nobel Laureate Harry M. Markowitz: "Many observers, including Dr., Jacobs and me, believe that the severity of the 1987 crash was due, in large part, to the use before and during the crash of an option replication strategy known as 'portfolio insurance.' In this book, Dr. Jacobs describes the procedures and rationale of portfolio insurance, its effect on the market, and whether it would have been desirable for the investor even if it had worked. He also discusses 'sons of portfolio insurance," and procedures with similar objectives and possibly similar effects on markets, in existence today."

From Dr. Jacobs' introduction: "This book ... examines how some investment strategies, especially those based on theories that ignore the human element, can self-destruct, taking markets down with them. Ironically, the greatest danger has often come from strategies that purport to reduce the risk of investing.

***

"In 1987, as in 1998, strategies supported by the best that finance theory had to offer were overwhelmed by the oldest of human instincts - survival. In 1929, in 1987, and in 1998, strategies that required mechanistic, forced selling of securities, regardless of market conditions, added to market turmoil and helped to turn market downturns into crashes. Ironically, in 1987 and 1998, those strategies had held out the promise of reducing the risk of investing. Instead, they ended up increasing risk for all investors."

***

I would like to explore the concepts behind the current dangerous fad of derivatives as a mechanism to insure against rising interest rates, as well as the momentous ramifications to both financial market and economic stability from these instruments that rely on dynamic hedging strategies. From Jacobs: "Option replication requires trend-following behavior - selling as the market falls and buying as it rises. Thus, when substantial numbers of investors are replicating options, their trading alone can exaggerate market trends. Furthermore, the trading activity of option replicators can have insidious effects on other investors."

Dr. Jacobs adeptly makes the important point that the availability of portfolio insurance during the mid-1980s played a significant role in fostering speculation that led to the stock market bubble and the crash that followed in October 1987. "Rather than retrenching and reducing their stock allocations, these investors had retained or even increased their equity exposures, placing even more upward pressure on stock prices. And, of course, as equity prices rose more, 'insured' portfolios bought more stock, causing prices to rise even higher…Ironically, the dynamic trading required by option replication had created the very conditions portfolio insurance had been designed to protect against - volatility and instability in underlying equity markets.And, tragically, portfolio insurance failed under these conditions (because…it was not true insurance). The volatility created by the strategy's dynamic hedging spelled its end."

***

"In the months following the (1987) crash, a number of investigative reports examined the trading data for the crash period. The Securities and Exchange Commission and the Brady Commission (the Presidential Task Force), for two, found that the evidence implicated portfolio insurance as a prime culprit." ...

Dr. Jacobs' wonderful effort explains ... the potential dangers of a complex financial theory taken up with little appreciation of its suitability for real-world conditions and applied mechanistically with little regard for its potential effects. It is a story about how a relatively small group of operators, in today's complicated and interconnected marketplaces, can wreak havoc out of all proportion to their numbers…it is a story of unintended consequences. For synthetic portfolio insurance, although born from the tenets of market efficiency, affected markets in very inefficient, destabilizing ways. And option replication, although envisioned as a means for investors to transfer and thereby reduce unwanted risk, came to be a source of risk for all market participants."

Unfortunately, this language seems at least as applicable to today's interest rate derivative market as it was for equity portfolio insurance. It is certainly our view that the contemporary U.S. and global financial system characterized by unfettered money, credit and speculative excess creates unprecedented risk for all market participants, as well as citizens both at home and abroad. Not only have flawed theories prevailed and past crises been readily ignored, derivatives (interest rate in particular) have come to play a much greater role throughout the U.S. and global financial system. The proliferation of derivative trading is a key element fostering credit excess and a critical aspect of the monetary processes that fuel recurring boom and bust dynamics, as well as the general instability wrought by enormous financial sector leveraging and sophisticated speculative strategies. This certainly makes the proliferation of interest rate derivatives significantly more dangerous than stock market derivatives. Under these circumstances, it does seem rather curious that more don't seriously question the soundness of this unrelenting derivative expansion. Unfortunately, ignoring the dysfunctional nature of the current system does not assist in its rectification - anything but. Indeed, it is my view that these previous market dislocations will prove but harbingers of a potentially much more problematic crisis that is quietly fermenting in the U.S. (global) credit system.

***

Clearly, the gigantic interest rate derivative market should be recognized as a very unusual beast. Instead of providing true interest rate hedging protection, this is clearly the financial sector having created a sophisticated mechanism that, despite its appearance, is limited to little more than "self insurance" - "The Son of Portfolio Insurance." I have written repeatedly that markets cannot hedge themselves, and that derivative "insurance" is different in several critical respects from traditional insurance. From Dr. Jacobs: "Synthetic portfolio insurance differs from traditional insurance where numerous insured parties each pay an explicit, predetermined premium to an insurance company, which accepts the independent risks of such unforeseeable events as theft or fire. The traditional insurer pools the risks of many participants and is obligated, and in general able, to draw on these premiums and accumulated reserves, as necessary, to reimburse losses. Synthetic portfolio insurance also differs critically from real options, where the option seller, for a premium, takes on the risk of market moves." Such exposure to unrelated events is far different from exposure to a market dislocation. Quoting leading proponents of portfolio insurance from 1985, "it doesn't matter that formal insurance policies are not available. The mathematics of finance provide the answer…The bottom line is that financial catastrophes can be avoided at a relatively insignificant cost."

Amazingly, such thinking persists to this day. The above language, of course, is all too similar to the flawed analysis/erroneous propaganda that is the foundation for the proliferation of hedging strategies and the explosion of derivative positions. Dynamic hedging makes two quite bold assumptions that become even more audacious as derivative positions balloon: continuous markets and liquidity. As writers of technology puts ...experienced, individual stocks often gap down significantly on earnings or other disappointing news, not affording the opportunity to short the underlying stock at levels necessary to successfully hedge exposure. And when the entire technology sector was in freefall, market illiquidity made it impossible for players to dynamically hedge the enormous amount of technology derivatives (put options) that had been written over the boom (especially during the final stage of gross speculation). The buying power necessary to absorb the massive shorting necessary for derivative players to offload exposure (through shorting stocks or futures) was nowhere to be found - so much for assumptions.

Granted, derivatives can be a very effective mechanism for individual participants to shift risk to others, but a proliferation of these strategies significantly influences their effectiveness and general impact. The availability of inexpensive "insurance" heightens the appetite for risk and exacerbates the boom. This characteristic has significant ramifications for both the financial system and real economy. It also creates completely unrealistic expectations for the amount of market risk that can be absorbed/shifted come the inevitable market downturn. Many adopt strategies to purchase insurance at the first signs of market stress. Once again, the market cannot hedge itself, and the tendency is for derivative markets operating in a speculative environment to transfer risk specifically to financial players with little capacity to provide protection in the event of severe financial market crisis.

***

There is another key factor that greatly accentuates today's risk of a serous market dislocation, that was actually noted by the BIS: "Net repayments of US government debt have affected the liquidity of the US government bond market and the effectiveness of traditional hedging vehicles, such as cash market securities or government bond futures, encouraging market participants to switch to more effective hedging instruments, such as interest rate swaps."

This is actually a very interesting statement from the BIS. First, it is an acknowledgement that "liquidity" and the "effectiveness of traditional hedging vehicles" have been impaired, concurrently with the exponential growth of outstanding derivative positions. This is not a healthy divergence. We have posited that the explosion in private sector debt, having been the leading factor fueling U.S. government surpluses, has produced The Great Distortion. As such, the viability of hedging strategies such as those that entailed massive Treasury securities sales in 1994 is today suspect. There are fewer Treasuries and a much less liquid Treasury market, in the face of unimaginable increases in risky private-sector securities and hedging vehicles. And while this momentous development has not yet created significant market disruption, the true test will come in an environment of generally increasing interest rates. Rising market rates will dictate hedging-related securities sales, and will test the liquidity assumptions that lie at the heart of derivative strategies. It is certainly my view that models that rely on historical relationships between public and private debt are increasingly inappropriate in today's bubble environment, as are the associated assumptions of marketplace liquidity. Importantly, dynamically shorting securities in the liquid Treasuries market is no longer a viable method for the financial sector to hedge the enormous interest rate risk that they have created. The "answer" to this dilemma, apparently, has been an explosion of "more effective hedging instruments, such as interest rate swaps (from the BIS)." We very much question the use of the adjective "effective." ...

All the same, the interest rate swaps market remains Wall Street's favorite "Son of Portfolio Insurance." A similar pre-'87 Crash perception of a "free lunch" conveniently opens the door to playing aggressively in a speculative market. But an interest rate swap is only a contact to exchange a stream of cash flows, generally with one party agreeing to pay a fixed rate and the other party a floating rate (settling the difference with periodic cash payments). With characteristics of writing an option, the risk of loss is open ended for those taking the floating side of the swap trade. There's no magic here, with one party a loser in this contract in the event of a significant jump in market rates. In such an event, this "loser" will certainly plan to dynamically hedge escalating exposure. If you are on the "winning" side, you had better accept the fact that the greater your "win," the higher the probability of a counterparty default. Somewhere along the line, these hedging strategies must be capable of generating the necessary cash flow to pay on derivative "insurance" in the event of higher interest rates. Obviously, the highly leveraged and exposed financial institutions that comprise the swaps market have little capacity to provide true insurance. In a rising rate environment, these players will have enough problems of their own making as they are forced to deal with their own bloated balance sheets, mark-to-market losses [what a quaint notion], and other interest rate mismatches, let alone enormous off-balance sheet exposure. As I have written previously, purchasing large amounts of protection against sharply higher interest rates from the U.S. financial sector makes about as much sense as the failed strategy of contracting with Russian banks for protection against a collapse in the ruble. Sure, one can play this game, but we are all left to hope that the circumstances never develop where there is a need to collect on these policies.

***
At some point, higher interest rates will force the financial sector to short securities to dynamically hedge the massive interest rate exposure that has been created. What securities will be sold and from where will buyers be found with the necessary $100s ($ trillion plus?) of billions of liquidity? Will agency securities be aggressively shorted? What are the ramifications of such a development to a market that is almost certainly highly leveraged with enormous speculative trading? I can assure you that these are questions that the derivative players would rather not contemplate, let alone discuss. ...

The problem is that the strong perception that has developed that holds that the Fed will ensure that interest rates and liquidity conditions remain market friendly is actually the key assumption fostering the explosion in interest rate derivatives and reckless risk-taking. It should be clear that the assumptions of liquidity make no sense whatsoever without the unspoken assurances from the Federal Reserve. The resulting proliferation of derivatives, then, has played a momentous role in the intermediation process whereby endless risky loans are transformed into "safe" securities and "money." The credit system's newfound and virtually unlimited capability of fabricating "safe" securities and instruments is the mechanism providing unbounded availability of credit - the hallmark of "New Age Finance." It is the unbounded availability of credit that, at this very late stage of the cycle, that creates extreme risk of dangerous financial and economic distortions, including the distinct possibility of heightened inflationary pressures. Ironically, the proliferation of interest rate derivatives has created the very conditions that they had been designed to protect against - volatility and instability in the underlying credit market, as well as acute vulnerability to the real economy.

***

The bad news is that there sure is a lot riding on what appears to be one massive and increasingly vulnerable speculation and derivative bubble that fuel the perpetuation of the historic U.S. Credit Bubble. I have said before that I see the current bets placed in the U.S. interest rate market as probably "history's most crowded trade."

Conclusion

Most economists and financial institutions assume that interest rate derivatives help to stabilize the economy.

But cumulatively, they can actually increase risky behavior, just as portfolio insurance previously did. As Nassim Taleb has shown, behavior which appears to decrease risk can actually mask long-term risks and lead to huge blow ups.

Moreover, there is a real danger of too many people using the same strategy at once. As economist Blake LeBaron discovered last year, when everyone is on the same side of a trade, it will likely lead to a crash:

During the run-up to a crash, population diversity falls. Agents begin using very similar trading strategies as their common good performance is reinforced. This makes the population very brittle...

Given that the market for interest rate derivatives is orders of magnitude larger than credit default swap market - let alone portfolio insurance - the risks of a "black swan" event based on interest rate derivatives should be taken seriously.

Anything that is orders of magnitude larger than the global economy could be risky - one unforeseen event and things could destabilize very quickly. Too much of anything can be dangerous. Water is essential for life ... but too much and you drown.

But I am confident that no one - even the people that design, sell or write about the various interest rate derivatives - really know how much of a danger they do or don't pose to the overall economy. In addition to all of the other complexities of the instruments, the very size of the market is unprecedented. Independent risk analysts would do a great service if they quantified and modeled the risk.

Finally, even if the widespread use of interest rate derivatives does not harm the economy as a whole, it will certainly harm the cities, states and other governmental and quasi-governmental entities which are on the wrong side of the trade. My hunch is that - just as the fraud in the CDO and CDS markets was exposed when the "water level" of the economy fell, exposing the rocks underneath - rising interest rates will reveal massive fraud in the interest rate derivative market.

 

 

Things you can do from here:

• Subscribe to Washington's Blog using Google Reader
• Get started using Google Reader to easily keep up with all your favorite sites

 

 

Train Notes 4/15/2010

Here are the Train Notes for Thursday, April 10, 2010

Both the Federal Reserve and the International Monetary Fund warned of
prolonged high unemployment levels in the US. While the Fed didn't
provide any details, the IMF projected that unemployment levels in
developed countries such as the US will remain high for the next two
years. Currently the unemployment rate is just under 10% and the IMF
estimates tha the level will remain around 8% through 2011. This
assessment has cooled the positive economic data that is coming
through this week. Retail sales were up 1.6% last month, which was
better than expected. However, high levels of unemployment will cap
long-term growth in consumer spending. This means the recovery will
likely proceed at a slower, longer rate.

Finally, information on industrial production is expected to show some
positive gains today.

Sent from my iPhone

Who really caused the market collapse?

A little over a week ago I wrote about why foreclosures were still occuring, see here.  In that post I described how banks would repackage subprime mortgages into CDOs and then resell them to investors.  Over the past few days more evidence is surfacing that the "investors" were either the investment banks that created the CDOs or these banks were essentially insuring the prdducts because most investors wouldn't otherwise touch them, see this Naked Capitalism post.  Or the investors knew these products would tank and took short positions that allowed them to considerably profit during the downfall, see here.

As more evidence surfaces regarding this nefarious behaviour, public anger against investment banks is likely to rise again.  This could affect the financial reform moving through Congress.  Particularly, these previously unregulated products are likely to have more light shed on them.  Regardless, this behaviour clearly shows that many investment banks--especially the "to big to fail" ones--cannot be left alone to develop and push "innovative" finanical products.  I'm not sure what the appropriate response to this behaviour is, but certainly it's not more bailout money (if such money is needed).  Even if the failure of these institutions would send us into another recession, perhaps that is best in the long run.

Train Notes 4/14/2010

Here are the Train Notes for Wednesday, April 14, 2010

There are very few headlines today. The U.S. Trade deficit rose 7.4
percent in February, which oddly suggests economic strengthening as
consumers and businesses purchase more goods. By now everyone in
America should realize that we are not an export drive country, at
least not for goods. Our economy is based more on services and
technology development.

Also, Greece managed to raise $2 billion at 4.55% from investors. This
rate is lower then the proposed EU bailout rate of 5%, but it is still
very high. Greece needs to raise at least $15.6 billion next month,
which may be possible given the recent interest in Greek bonds.
However, Greece still needs to lower the interest rates on it's bonds
(through additional government spending cuts) or it won't be able to
make interest payments over the long run. Greece is a test case for
potential so erign default (basically a government that is unable to
pay for it's loan interest). A Greek default could have widespread
effects on the global economy. If it fails it would raise fears in
other struggling countries, which could result in a domino effect that
causes more countries to default. This situation is akin to your
neighbor defaulting on his mortgage, which causes a foreclosure and
lowers your property value while simultaneously causig banks to lend
less money. The result is less flexibility and growth onthe econmy.

Sent from my iPhone