Brent Nyitray
Fairlington Blade
Let the mutherfuker burn!
jnc4p
Kevin S. Willis
Michigoose
lmsinca
markinaustin
Arcanaut
novahockey
quarterback
ScottC
yellojktVital Statistics:
| Last | Change | Percent | |
| S&P Futures | 1319.1 | 3.4 | 0.26% |
| Eurostoxx Index | 2181.4 | 31.3 | 1.45% |
| Oil (WTI) | 92.34 | -0.2 | -0.25% |
| LIBOR | 0.467 | 0.000 | 0.00% |
| US Dollar Index (DXY) | 81.2 | 0.119 | 0.15% |
| 10 Year Govt Bond Yield | 1.78% | 0.04% | |
| RPX Composite Real Estate Index | 175.7 | 0.1 |
Markets are generally firmer this morning on hopes of further stimulus out of China and Europe. Euro sovereign yields are lower. US bond futures are down a point and MBS are down slightly. MBS underperformed bonds in the rally, so they should outperform as bonds retrace.
Richmond Fed came in below expectations. This survey looks at the service sector for Richmond, Baltimore and Charlotte. Revenues actually contracted in May. They note that service providers expect stronger customer demand over the next six months, while retailers do not.
Existing Home Sales came in at 4.62MM annualized. 5.5 million is about “average.” The number is up 10% YOY. The lack of distressed sales and the seasonal move towards bigger houses increased the median price 10% from 161,100 to 177,400. Overall, it notes that the headwinds in the real estate sector are abating.
Yesterday we had a number of sizeable mergers, with Eaton buying Cooper Industries for 12.8 billion, DaVita buying Healthcare Partners for 4.5B and Wanda Group buying AMC. Generally speaking, mergers are a good sign for the markets and the economy in general.
Andrew Ross Sorkin has a good column on why Glass Steagall wouldn’t have prevented the crisis. The Glass-Steagall issue has become a facile explanation of what went wrong. Elizabeth Warren even acknowledges this – one of the reasons she has been pushing reinstating GS – even if it wouldn’t have prevented the financial crisis – is that it is an easy issue for the public to understand and “you can build public attention behind.” And there you have it. Never mind that nobody else in the world (the UK, Europe, Japan, Canada) separates commercial and investment banking, or even draws a distinction between the two.
What was the rationale behind Glass-Steagall in the first place? Poorly underwritten deals (for example, Facebook). Facebook was the quintessential poorly underwritten deal. An underwritten deal means that the investment banks (primarily Morgan Stanley) actually write a check to the company and buy 421MM shares at 38. It then places those shares with institutional investors. If the deal is handled well, Morgan Stanley sells all the stock, collects its fee and moves on. This deal did not go well, obviously. Institutional investors sold into the market and FB was in danger of breaking price. Morgan Stanley stood in the market and bought everything that the market was willing to sell at the offer price. (If an IPO breaks price on the first day, that is a MAJOR embarrassment to the investment bank). So Morgan Stanley is now lugging millions of Facebook shares that it bought in the market at 38. The stock is trading at 32.65. Huge loss. Pre-Glass Steagall, what would they do? Sell the stock to their captive commercial bank at 38. (Hey, we bumped up your allocation to 5 million shares) Institutional investors will pull their money out quickly if they sense an investment bank is in trouble. Depositors at a sleepy commercial bank? Not so much. Note: This was done more with bond issues than stock issues, but the rationale remains the same. In the Great Depression, commercial banks were failing and it turned out their assets were not home mortgages or commercial loans – they were all the lousy deals their sister investment bank couldn’t unload. That is why we had Glass-Steagall – to prevent commercial banks from being repositories for losing positions.
Fast forward to the financial crisis – commercial banks weren’t failing because they bought CDO-squared issues from their investment banking divisions. Or because Citi was stuffing its retail bank with LBO paper it couldn’t unload. The reason we had a financial crisis is because we had a residential real estate bubble. Every bank in the US is exposed to residential real estate in some way, shape, or form. And it didn’t matter whether you were exposed to residential real estate through a mortgage backed security or through holding whole loans on your balance sheet. The small community banks who wouldn’t know a CDO from a codfish blew up just the same as the big integrated banks
Probably the single best thing regulators could do to prevent a re-occurrence would be to deal with the cascading counterparty risk from OTC derivatives. They should demand that OTC derivatives become standardized and exchange-traded with a central clearing party, position limits, and open interest disclosure. That would have prevented AIG from taking the positions it did and exposing all of its counterparties when it failed.
Filed under: Morning Report |
All Things in Moderation 
“That is why we had Glass-Steagall – to prevent commercial banks from being repositories for losing positions.”
Leaving aside the recent real estate bubble and associated financial crisis, do you view a replay of the original behavior from the Great Depression as a potential future risk? I.e. could JP Morgan Chase if it was the underwriter for Facebook have dumped their shares into the commercial bank side of the business?
On a broader note, I believe that too many issues are conflated under the rubric of “financial market reform”. The goal of reform should not be to always make the stock market go up, or to prevent trading losses, or even to prevent future bubbles, which I believe is ultimately a fool’s errand. The goal should be to prevent the need for another TARP like bailout and the associated privatized profits and socialized losses. If there is a bubble, the losses should be borne by those who were profiting and/or attempting to profit on the way up.
And while I realize that Scott’s position is ultimately a truism (i.e. the only way to guarantee that there won’t be another bailout is to elect politicians who won’t do the bailout) I do believe that there are market reforms that can reduce the perceived need to do so in the future. The most obvious seems to be breaking up the Too Big Too Fail banks through either anti-trust enforcement or a tax on size such as the one Jon Huntsman advocated in the WSJ.
http://online.wsj.com/article/SB10001424052970204346104576635033336992122.html
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Speaking of Facebook, I find it amusing that the current stock price is viewed as a failure of marketing by Morgan Stanley, rather than an appropriate price based on Facebook’s fundamentals.
http://dealbook.nytimes.com/2012/05/21/as-facebooks-stock-struggles-fingers-start-pointing/
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Banned: Sticking to my guns on Germnay blocking Eurobonds:
“Germany, France draw battle lines over eurozone bonds
By Noah Barkin and Leigh Thomas
BERLIN/PARIS | Tue May 22, 2012 10:48am EDT
(Reuters) – Germany dismissed a French-led call for euro zone nations to issue common bonds, a day before a European Union leaders’ summit which investors are looking to for new measures to counter the bloc’s debt crisis.”
http://www.reuters.com/article/2012/05/22/us-eurozone-idUSBRE84L0OD20120522
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Been busy, but today is a bit more calm…well at least this morning is. Anyway, great post on Glass Steagal and interesting comments from jnc (as always). I like the view that the goal of any regulations should be to avoid the need for a bailout. I don’t know to what extent that may create some overlap in the prevention of bubbles, but if people, banks, investment institutions etc. want to make bad decisions, we should let them do so. I would imagine that knowing no bailout is coming would be a pretty big deterrent in taking on too much risk.
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“Leaving aside the recent real estate bubble and associated financial crisis, do you view a replay of the original behavior from the Great Depression as a potential future risk? I.e. could JP Morgan Chase if it was the underwriter for Facebook have dumped their shares into the commercial bank side of the business?”
I don’t think that would work for a stock like facebook, where the market price is easily observed. For bonds, there may be a bit of an arbitrage possibility. Say JPM does a crappy bond deal and is stuck with a hundred million bonds that it couldn’t sell. The price of the bond drops to 95. Could JPM sell the bonds to Chase at par, and would Chase be allowed to move them from the “securities trading” account to the “held to maturity” account? In the “securities trading” account, you have to mark them at whatever the market price is. In the “held to maturity” account, you are generally allowed to mark them at par unless the bond is impaired. Theoretically, yes.
That said, if we re-instate Glass Steagall, prepare for “Wall Street” to become UBS, CSFB, and Deutsche Bank. Because they can fund their balance sheets with deposits they have a competitive advantage over the US investment banks who have to fund their balance sheets at LIBOR. That was one of the reasons why we got rid of GS in the first place.
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Brent:
Thanks for the analysis. So, is there no transparency at all for OTC derivatives? How do you know what you’re trading? Would you move the OTC derivatives to the existing exchange or create a new one for these types of contracts?
I know, I’m full of questions.
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Mike:
Would you move the OTC derivatives to the existing exchange or create a new one for these types of contracts?
The problem with trying to move OTC derivs to an exchange is that doing so will then destroy the value of the product. There are already derivative contracts that trade on an exchange. The value of OTC derivatives derives from the fact that they can be specifically tailored to individual needs, which is not true of exchange traded products.
I’ll give a very basic example. I spoke the other day about eurodollar futures contracts and their relationship to libor. Well, a eurodollar futures contract is basically an exchange traded derivative, a contract which derives its value from the libor setting on certain days in the future. The exchange trades 4 eurodollar contracts for each year in the future, and the contract expires on the third Wednesday of every March, June, September, and December. So, by buying or selling a series of consecutive contracts, one is essentially replicating a fixed rate swap for a given term. For example, if today I buy 100 each of the first 8 contracts, I have effectively received fixed and paid floating on a $100mm swap for 2 years starting in the middle of June and ending in the middle of June in 2014, with floating reset dates each quarter in June, September, December and March.
But suppose I am trying to hedge the rate risk on a loan that starts on May 1st and has monthly rather than quarterly resets? The above exchange traded contracts will give me a macro hedge, but I will still have risk, specifically mismatching reset risk, both in timing (1st of the month vs than middle of the month) and duration (3m vs 1m). An OTC swap can easily solve this problem, because I can tailor the swap to match the reset dates on the underlying loan exactly, and eliminate all rate risk. Again, the value of OTC derivatives lies in their very flexibility to be tailored to whatever needs one has, a flexibility that is just not possible with exchange traded contracts that require standard terms and definitions.
I think the desire to move OTC derivs to an exchange is somewhat misdirected. The thing that makes exchange traded products preferable to OTC (from a public policy point of view) is that exchanges require initial and daily mark-to-market margin to be posted, so any potential default is largely covered by margin already paid. By forcing OTC derivs to clear through a clearing house, this benefit is largely achieved even without an exchange. Although I do have to say that moving to a clearing house model is not problem-free. If the failure of AIG presented the risk of cascading credit defaults, imagine what the failure of a clearing house, to which every major bank in the world has been forced by law to expose itself, would create. If you think JPM is Too Big To Fail, you ain’t seen nothing yet.
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Relinking from a PL post by Shrink that I thought was worthwhile:
“The anatomy of the eurozone bank run
May 20, 2012 4:21 pm by Gavyn Davies
A bank run is now happening within the eurozone. So far it has been relatively slow and prolonged, but it is a run nonetheless. And last week, it showed signs of accelerating sharply, in a way which demands an urgent response from policy-makers.”
http://blogs.ft.com/gavyndavies/2012/05/20/the-anatomy-of-the-eurozone-bank-run/#axzz1vdDO9Ysl
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Interesting note from the PBS NewsHour tonight. The United Arab Emirates(UAE) has donated millions of dollars to help rebuild the schools and hospitals in Joplin, Missouri following the tornadoes a year ago today.
http://www.pbs.org/newshour/bb/science/jan-june12/joplin_05-22.html
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Steve Pearlstein on the JP Morgan Chase loss:
http://www.washingtonpost.com/jpmorgans-soap-opera-makes-clear-that-wall-street-is-detached-from-reality/2012/05/18/gIQAIJwvbU_story.html
Worth noting:
“In their rush to switch gears and sell rather than buy risk protection using these new derivatives contracts, however, the JPMorgan crew apparently wound up driving the price of insuring the entire index below the price of protecting the individual corporate bonds that make up the index. That rang a bell at a number of hedge funds that are constantly trolling the market for a chance to make a quick buck from such discrepancies by buying one and selling the other. Their profitable arbitrage had the effect of driving down the market value of JPMorgan’s positions, which under accounting rules required the bank to post a giant paper loss. The bank’s position was so large that it could not begin to unwind it without driving down the price even further.”
I believe this corresponds with earlier speculation here.
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jnc, Pearlstein’s column corresponds with earlier speculation here re: Chase, but its conclusion restates my fear that Scott is overrating the benefit of naked positions and synthetic derivatives and understating the potential damage from the crapshoot.
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mark:
my fear that Scott is overrating the benefit of naked positions and synthetic derivatives
I don’t rate the benefit of naked positions at all. Naked positions may be detrimental or they may be beneficial, depending on the direction of the market. I simply point out the truism that “naked” positions wiil exist as a result of the very banking activity of which you approve, and in many instances the only way to hedge these risks is when someone else is willing to take it on (ie hold a “naked” position) through the use of derivatives. To demonize either derivatives as a product or the act of taking on “naked” risk through the use of derivatives is to ignore the real problem.
The real problem is not the manner in which banks take risk (whether, for instance, it is lending money to residential real estate purchases or selling CDS protection on residential mortgages packaged as a CDO), but rather the amount of risk they take in either event.
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A political pollster called tonight and refused to register my support for Gary Johnson or even “none of the above”. Choice had to be Obama or Romney. Very annoying. Only thing worse was having to pick between George Allen & Tim Kaine for Senate.
The amusing part was answering the “Does this statement make you more or less likely to vote for X” questions with “Since the statement itself is false, neither.”
Also, anytime a candidate was accused of wanting to cut Medicare, I responded that it made me much more likely to support them. I don’t think that was the answer they were expecting.
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jnc:
Sounds like you got push-polled. It’s an obligation to mess with push-pollers — nicely done.
MiA adds: I had a client, now deceased, who when he heard a push-poll question would say “it’s hard to pay attention to you while I’m getting such great head.”
I’ve never tried it, but I heard him do it once, and the caller hung up.
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JNC — do you know if the LP has a candidate for Senate in VA? haven’t seen anything online, so assume no.
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Scott:
Thanks for the explanation.
the value of OTC derivatives lies in their very flexibility to be tailored to whatever needs one has, a flexibility that is just not possible with exchange traded contracts that require standard terms and definitions
So, the regulatory issue isn’t transparency per se, but the tremendous quantity of individualized swaps that occur and having to examine each one?
Just to get an idea of size of the OTC derivative market, what is the volume of OTC contracts relative to exchange-traded derivatives? I guess that would also relate to how “big” the clearing houses would be to handle the traffic.
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Mike:
I’m not sure exactly how to answer your questions, but hopefully this will help. The reported “size” of a given derivatives market is not always all that meaningful. For example, with regard to simple interest rate swaps, the size of the market is most often reported in terms of notional amount on swaps done…$X trillion in notional amount of swaps executed, or something like that. But this actually isn’t particularly interesting information, because it is the risk size that is relevant, and a) the dollars at risk on a simple IRS are no where near the size of the notional and b) the duration of a contract has a huge effect on the risk. A $200mm 2 year swap has rate risk of about $40k for a 1 basis point move in the 2 year rate. This means that a move of 2% in rates, an absolutely massive move, would result in a loss/gain of about $8 million on that $200mm 2yr position, but a $43mm 10 year swap has a similar risk profile. So if someone says they’ve done $1 billion worth of swaps, you really haven’t learned anything noteworthy at all. That amount could be comprised of a portfolio of 10 swaps or a single swap, of swaps with all kinds of different durations or a single duration, and indeed even different directions (pay and receive fixed). The risk profile of the whole portfolio could even conceivably close to $0 if it was reasonably balanced with swaps going in different directions. So to talk about the “size” of swap market isn’t always useful, either in terms of notional amount or number or transactions. However, in some instances it can be. If someone is selling credit protection via CDS, then saying that you’ve sold protection on a total of $X billion is meaningful because that amount really is at risk (although duration is also a relevant but unstated factor.)
This ties into something that I find very irritating in political/media discussions of derivatives. There are all kinds of different derivative markets, with different kinds and degrees of risk. To speak of “derivatives” as a generic, singular product, and to say one is going to regulate the “derivatives market” as if it is a single market, as Dodd/Frank does, is totally absurd. The fixed income derivatives market, which played virtually no role at all in the threatened cascade of defaults back in 2008, is entirely different to say, the CDS market, which played a large role. Fixed income derivs have a totally different kind of risk, are better understood in terms of value and risk, and the market is much deeper and more liquid, particularly in times of stress, which provides users with much better price transparency and an ability to hedge open positions. Yet D/F and the regulators implementing it make no attempt to distinguish between interest rate swap dealers and credit default swap dealers. Everyone is simply a “swap dealer” subject to the same reporting requirements, the same registration requirements, the same notional size exemptions (one of many simply laughable elements of the proposed rules). Even if one assumes that strict regulation is both desirable and attainable, they way the have gone about it it is simply crazy.
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Scott:
That was very helpful. Thanks.
How do you calculate risk profiles ($$, duration, position)? Is there a metric for risk that can be used to compare between the different types of derivatives? Or are risk profiles more subjective, depending on the firm/trader/software?
I’m sure there’s a lot more math in it than I can handle (probably lots of Greek symbols too). A bunch of my fraternity brothers ended up on Wall St. after college — all of them were CS/EE majors.
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Mike:
It’s difficult to compare risk across markets, since generally risk represents the $ amount gained or lost due to a standard change in some unit of value of the underlying instrument upon which the derivative is based, and these units of value are not necessarily directly comparable across products. For example, in an oil commodity swap the risk will be measured as the amount of dollars made or lost due to a 1 cent change in the value of Brent crude oil. In a 2 year interest rate swap the risk will be measured as the amount of dollars made or lost due to a 1 basis point change in the 2 year swap rate, which is a direct function of the 2 yr treasury yield. So, while the risk of the commodity swap may be exactly equal in dollar terms to the 2 yr IRS, they aren’t directly comparable in any meaningful sense because they are measuring sensitivity to two entirely different things, a commodity price in one case and an interest rates in the other.
Generally speaking measured risk is not subjective at all, although it is possible that in some particularly esoteric or complex structures, some of the inputs used to calculate a price might be subjective. This is especially true in less active and less well defined markets. If the market for a particular kind of risk is illiquid, you may have to make some assumptions in order to value it.
Calculating risk for an interest rate swap is very easy. Recall that a simple IRS is nothing more than an exchange of cash flows between two parties on certain dates in the future. Generally one set of cash flows are based a fixed rate throughout the swap and the other set of flows are based on a floating rate index (usually libor) and will be reset at periodic intervals throughout the life of the swap. I can get more into the details if you want, but very basically today’s yield curve, built from known market rates for various maturities, allows you to calculate 1) forward Libor rates implied by todays rates and 2) discount factors. Once you have those two things, all you do is calculate what the cash flows are expected to be on dates in the future (the known fixed rate minus the forward
rate times the notional amount times the day count) and then discount those cash flows using your discount factors. This gives you the value of the swap. Then, to calculate risk, you simply shift your yield curve, one maturity at a time, by 1 basis point, and recalculate the value. The change in value after the shift tells you what your risk is. it really is that simple.
As I said, I can get more detailed if you are really interested, but if I do I can’t guarantee that you won’t become corrupted by the evil influences of this financial black magic. 🙂
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Scott, re OTC derivatives.
Re the customization issue, I would point out that equity options now have weekly expiries and calendar month expiries. I don’t see why we can’t have weekly expiries in futures contracts. I would venture to say that weekly and calendar monthly expiries would cover the vast majority of term mis-matching problems.
I think investors would prefer these products to be exchange-traded for the simple fact that when you trade an OTC derivative with a bank, they always know which way you are. If you put on a swap with Goldman and want to get out, you have to go back to Goldman to get a price. If you don’t like their price, you can either set up an offsetting swap with someone else, or grit your teeth and pay whatever Goldman is asking. IMO, this sort of activity helped drive up the sheer growth of notional value of OTC derivatives.
If you set up credit default swaps on an exchange, you would run it like an equity options exchange, where there are position limits, contract limits, and most importantly – closing transactions. There would be daily open interest disclosure with time and sales data. While the investment banks would lose the last profitable business area, investors would be delighted, IMO.
The biggest problem with OTC derivatives is the cascading counterparty risk. As you know, even though the notional amounts never change hands, they still are there. And even though periodic payments are netted out, there still are two separate payments. If you have a swap with Lehman and Lehman files BK, you are 1/2 creditor and 1/2 debtor. As a creditor, the periodic payments you receive from Lehman are suspended, but the periodic payments you owe to them do not. Think about what happens if you have $250 billion swap book with Lehman. You are toast if they file.
That is a recipe to crush every major counterparty. If you had a central clearing party, with the fee paid with a per-ticket charge, position limits to prevent another AIG, you would go a long way towards preventing another contagion. Of course the central clearing party could bite the dust, but that is what position limits and daily margin are there to prevent.
I think moving as much as possible to an exchange would make a lot of sense. I could see it make sense for the banks if they set up their own exchange – it isn’t as if their loss need be the CME’s gain.
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Thank you Brent, and Scott, too.
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Brent:
If you have a swap with Lehman and Lehman files BK, you are 1/2 creditor and 1/2 debtor. As a creditor, the periodic payments you receive from Lehman are suspended, but the periodic payments you owe to them do not.
I don’t believe that is true. As I have pointed out, my area of knowledge is mostly based in the fixed income area, but one of the main things that ISDA master agreements govern is the ability to net in the situation of a credit event, not only within a given transaction but across all transactions with a single counterparty. That’s the whole point of entering into CSA agreements and having counterparties post collateral. Every day we calculate what is owed by us to CSA counterparties or vice versa across all transactions with that particular entity, and we either post collateral or collect collateral based on the net amount owed. If netting was not allowed in the event of bankruptcy, there would be no point to collecting the collateral.
When Lehman filed, we held collateral on transactions we had done with them because on a net basis they owed us. We kept that collateral and did not have to pay them anything. So our losses on the Lehman collapse were limited to the change in value of our portfolio with them between the last time they posted collateral and the point at which they actually filed. And to be honest, if I remember correctly, we actually made some small amount of money because between the time that they filed and we managed to hedge out the risk we were left with, the market moved in our favor.
It was definitely not the case that we had to make good on our side of our deals with them even though they didn’t make good to us.
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Brent:
Re the customization issue, I would point out that equity options now have weekly expiries and calendar month expiries. I don’t see why we can’t have weekly expiries in futures contracts.
How far out do the equity options go? IRS now trades out to 40 years. I think it would be pretty unlikely to get 40 years worth of weekly 3m Libor contracts to trade. even the quarterly contracts that they have now out to 10 years barely trade beyond the 5th year.
And the term and date mismatch problem was just an example of the flexibility benefit of OTC vs exchange traded contracts. Are exchanges going to create 6m Libor contracts? What about SIFMA contracts for muni swaps? Will there be odd tenor contracts for 2m and 4m Libor to accommodate deals that require stub interpolations? Currently there are eurodollar option contracts (EDOs), so it is possible to string together a strip of EDOs to replicate a cap or floor. But what about a swaption? Can an exchange really accommodate the contracts necessary to replicate the nearly limitless combination of option start and end dates on a swap?
Forcing OTC’s into an exchange will severely limit the ability of banks to design hedging solutions for their clients.
BTW, the very last thing that corporate end users of OTC derivs will want is for these to be put on an exchange. Dealers all have CSA agreements with each other and so already post collateral, but most end users do not. They are not going to want to have to be posting margin to an exchange just to hedge their most recent bond issue. Even Warren Buffet is lobbying congress to exclude corporate endusers like Berkshire from D/F clearing requirements.
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And, as if on cue, we get this from the WSJ today, channelling my comment yesterday about clearing houses:
Unfortunately, the WSJ unnecessarily demagogues the issue by pandering to xenophobic impulses:
First of all, LCH will not be acting as a clearing agent simply for “foreign derivatives trading”. US dollar denominated swaps between two US entities can be and are routinely being cleared through the London Clearing House. In fact, at the moment LCH is the dominant player and is winning the race to become the standard clearing house for most derivatives trades (at least within the fixed income market). If the goal of the legislation is to act as a backstop against a cataclysmic credit event that produces a domino effect of defaults – and I am not defending the goal, just stating it – then it would be absurd to exclude LCH simply because it resides outside the US.
And speaking of the race to become the standard clearing house, there are huge economic incentives for the market to establish a single clearing house for all trades rather than have a series of competing clearing houses. Because of initial margin requirements, it becomes very expensive to maintain positions with two different clearing houses. To take a simple example, imagine a portfolio of two completely and exactly offsetting trades that give you a zero risk position and have netted you a small profit. If both trades are cleared through a single clearing house, since your risk position is zero, you will not have to post any margin at all, and in fact the clearing house will owe you money because of the net profit you have made on the two trades. But now imagine that two trades are cleared through different clearing houses. That means that, although you personally are neutral and have zero risk, the individual clearing houses do not have zero risk to you, and so will demand some amount of initial margin to protect themselves. Since you don’t want to have to post margin, which can be expensive, on a position that you don’t even have, much less have to do it twice, you will do everything you can put all your trades into a single clearing house.
Needless to say, this move to concentrate all market credit risk in as few entities as possible is a recipe for disaster, but it is precisely what D/F and its mandates for clearing is going to produce. And is precisely why the clearing houses are indeed going to become TBTF.
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Scott, fair enough.. It has been a long time since I reviewed an ISDA agreement.
I remember having some swaps with Peregrine (the HK-based investment bank) when they went under during the Asian crisis in the late 90s. I seem to recall the problem of having to pay our side of the swap while they didn’t have to pay us. But that was a long time ago..
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Scott:
Thanks again for your comments and patience. I think I’m going to have to understand the financial black magic better to be corrupted by it. I’m going to let your posts percolate a bit in my head for a bit to see if my brain can arrange them — I’ll probably pepper you with questions again in a few days.
So, the difference in the risks among the types of swaps is partly due to the proportion of the notional amount that is actually at risk, i.e., percentage points in an IRS and the actual dollar amount in a CDS? I guess commodity swaps theoretically would risk the actual dollar amount, but in reality, oil isn’t going to drop below $1/bbl.
Consolidation of clearing houses sounds like a really bad idea.
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Mike:
I’ll probably pepper you with questions again in a few days.
Feel free. A lot of this stuff seems really complex at first, but once you get a couple of basic principles, it will all make sense and is actually pretty easy.
Consolidation of clearing houses sounds like a really bad idea.
There’s no perfect system. There is no way around the fact that the business of banking (and the wider financial world) involves taking risks, and it is impossible to protect the system from any and all downside consequences of risks gone bad.
In the pre-D/F world, most banks already had in place collateral agreements with each other, to protect themselves from potential defaults of other dealers. A few of the major dealers belonged to LCH, but it was a fairly exclusive club and most protection was derived through the use of CSA’s (Credit Support Annex) which mandated collateral payments. In theory this system of credit protection should work well, but the problem, highlighted in 2008, is that although on the surface it appears that credit risk is dispersed throughout the market and well capitalized, underneath it can still become concentrated in a few or even a single entity (like AIG), and the whole market can then be at risk to a single default, even though any given participant may not appear to have much risk at all to that single default. In really simple terms, I may not have deals at all with AIG, but if I am receiving collateral from, say, Goldman, who is receiving collateral from Morgan Stanley, who is receiving collateral from AIG, then ultimately I may be at risk should AIG stop paying and either Morgan or Goldman cannot cover AIG’s failure.
What D/F has done is not actually fix this implicit single-party default problem, but rather has made it explicit by directing the risk into a known entity (the clearing house) by law rather than an unknown entity by force of the market. Rather than mitigating the need for any future bailouts, it just means the government now knows who it will have to bail out when things go bad. (That’s not entirely fair…the initial margin requirements are designed to provide a cushion to the clearing house and thus make it less likely that they will default. But the point remains.)
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Mike asks many questions that I would ask, as I am following, but having to read slowly while trying to absorb the presentations sentence by sentence, and I don’t have the time to write. Thus I look forward to Mike’s questions, and answers from Scott and Brent.
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