agreed. Dont think theres enough money in the kitty for that event.

Yes and if B owes C after A defaulted on B, and then B will default on C and then C defaults on D because B defaulted on C because A defaulted on B, we have a problem to say the least.

Marty WEiss wrote this...at Financial Sense...scary stuff.

Citigroup and JP Morgan are in trouble it looks like...

The info I found particularly worrying was...

"And now, the OCC reports that JPMorgan Chase has a whopping $7.99 in credit risk per dollar of capital, or more than double its 1998 risk level!"

Basically they have 7 times the exposure of the total net worth of the company.

It also appears that JP Morgan had to buy Bear Stearns because if they didnt Bear Stearns would have taken JP Morgan with them

Anyway here is the full article.

The Gigantic,
Poorly-Known,
Highly Inflammable
Market For DERIVATIVES …

What are derivatives? Think of them as bets and debts by the super-rich and the world's largest companies.

What's the market for derivatives like? Think of it as a giant international casino:
In the main hall, they bet on the interest-rate roulette.
In the side rooms, they bet on foreign-currency blackjack, commodity craps or stock-market poker.
And in virtually every sector, the bets are financed with generous amounts of borrowed money.

But unlike ordinary markets that you and I are familiar with, this giant casino is not just about betting on a price that goes up or down. It's about betting on virtually every quirk and intricacy of nearly every investment under the sun.

Some of the bets are high risk; some are not.

Some are for hedging against losses; some, for outright speculation.

But everywhere, the dangers are undeniable:


Danger #1
The Sheer Enormity of the Derivatives Market

In its latest survey, the Bank of International Settlements (BIS) calculates that the total "notional" value of all derivatives outstanding in the world is a mind-boggling $415 trillion.

That's over eight times the GDP of the entire world economy … twenty times the total value of all U.S. stocks … and fifty times all the Treasury debts of the United States Government.

The fear: That any unexpected disruption in this $415-trillion market could throw the world's financial markets into turmoil … bankrupt hundreds of hedge funds … wipe out the profits of big-name financial institutions … sabotage the investments of pension funds … and scramble the portfolios of millions of average investors.


Danger #2
The Unbridled Growth

In 1998, the last time the derivatives market nearly blew up, there were "only" $80 trillion in derivatives outstanding worldwide, according to the BIS.

That was already huge.

But as I explained a moment ago, now the total derivatives outstanding has jumped to $415 trillion, or over FIVE times more!

And just from 2005 to 2006, it surged by a whopping 39.5%, about TEN times faster than the growth in the global economy.

Danger #3
Enormous Risks

If the risks were spread among thousands of institutions, each with plenty of capital to back up its bets, this derivatives balloon might not be such a threat.

But the U.S. Government's Office of the Comptroller of the Currency (OCC) reports that, in the United States …

Just FIVE banks control 97.1% of the derivatives in the entire U.S. banking system.

Worse, among these five banks, none — not ONE — has the capital to cover its net credit risk, the primary measure the OCC uses to evaluate the risks these banks are taking in their derivatives trading.


Back in 1998, at the time of the last debacle, JPMorgan Chase, the world's largest player in the derivatives market, had $3.80 in credit risk for each dollar of capital.

That was already over the top, in my view.

And now, the OCC reports that JPMorgan Chase has a whopping $7.99 in credit risk per dollar of capital, or more than double its 1998 risk level!

HSBC, which was barely a player in the derivatives market back in 1998, now has $5.65 in credit risk per dollar of capital!

Citibank: $2.03 per dollar of capital in 1998; $4.60 today.

Bank of America: 90 cents on the dollar in 1998; $2.88 today.

Wachovia: Just 18 cents on the dollar in 1998; $1.56 today.

This means that …
Even though Wachovia has the least exposure to derivatives among the top five, it is still extremely vulnerable — with more at stake than its entire capital.
America's largest bank — Bank of America — is also embroiled up to its eyeballs, risking over FOUR times its capital.
And the single largest player in the derivatives market - JPMorgan Chase - is taking the most risk of all: EIGHT times its entire capital, according to the OCC's data.

Danger #4
Scant Oversight or Control

Based on data compiled — but no longer published — by the OCC, less than 9% of the derivatives held by U.S. banks are traded on regulated exchanges.

The remaining 91% are strictly one-on-one contracts, handled over the counter, outside the domain of regulated exchanges.

This mean that each party is ultimately responsible for monitoring the credit and trustworthiness of each counterparty. They're on their own … leading me to the conclusion that …

Even Some of the Biggest Winners
Could Wind Up Among the Losers

Right now, everyone is worried about the big losers:
Hedge funds that poured too much money into bad mortgages …
Banks that financed the hedge funds, and …
Investors that own the bank shares.

And there's no question that many of these are in grave danger as a result of the mortgage meltdown.

But what most people don't seem to realize is that, in the tightly interconnected world of derivatives, even some of the biggest winners could wind up among the losers.

Let's say, for example, that you're running a mortgage company.

You've got a big stake in the subprime mortgage market. And you're getting hammered with one massive loss after another. So one morning, you wake up in a cold sweat and say:

"I can't take this any more! If this continues, it's going to wipe me out! I've got to buy some protection. I've got to place some bets on the opposite side!"

Like thousands of others in recent weeks, you rush to buy "credit default swaps" — in your case, special bets that are designed to go UP in value when your borrowers default. You figure it's good insurance.

Plus, as is the usual practice, in order to avoid putting up a lot of capital, you finance most of your new bets with short-term loans.

Finally, you figure you can sleep nights. If the mortgage market calms down, you anticipate that your regular operations will stabilize. Conversely, if the mortgage meltdown worsens, the profits likely on your new bets should help offset your losses. Either way, you're covered … or so you think.

Now … here comes the hidden nightmare: Long before you start cashing in your chips, you're shocked to learn that the other guy — the one on the losing side of the bet — has run out of capital! He's broke. And he won't pay you a single penny.

Bottom line: Even though you're on the winning side of the trade, you still lose. You lose on your regular mortgage operations. AND you lose on the new trade.

You run out of capital just like the others caught in the mortgage meltdown. And, just like the others, you default on your bank loans.

The crux of the problem: If you were trading on an established exchange, the other guy's default would be primarily the exchange's problem — not yours. It would be their responsibility to make sure the market participants have enough capital to back up their bets. It would be their job to go after anyone who doesn't meet his obligations.

But unfortunately, the exchange has very little to do with your transaction! Remember: As I stressed above, 91% of U.S. derivatives are strictly one-on-one contracts, handled over the counter, outside the domain of regulated exchanges.

In other words, it's between you and the other guy: If he pays up, fine. But if he stiffs you, tough luck!

Now do you see why there's so much concern in high places about the credit risk America's five biggest banks are taking?

Now do you see why central banks all over the world are dishing out such huge amounts of cash all of a sudden?

Their great fears:
A chain reaction of defaults that no government or exchange authority could control.
Huge losses at major international banks.
Massive convulsions in the world economy.

How to Protect Yourself

First, if you haven't done so already, get rid of your most vulnerable assets — investment real estate, mortgages, mortgage-backed securities, mortgage company stocks, bank stocks, brokerage firm stocks, and insurance company stocks.

But if you did not act on our earlier warnings, don't look back. Just focus on what you have to do now: SELL on rallies!

Second, take profits and raise cash, even on some of your best stocks.

This crisis is no longer limited to the investments we don't like. It's also bound to have an effect on areas we like, including some of our favorite foreign markets.

The global economic growth we've been telling you about is still strong. The fundamental forces pushing them forward are no less powerful. But that alone does not preclude sharp intermediate downturns.

So no matter what other investments you own — low-rated or high-rated, domestic or international — consider taking a chunk of your profits off the table.

Then stash most of the proceeds in short-term U.S. Treasury bills. Even if interest rates are low, even if the dollar is declining, short-term T-bills are still the ultimate place for safety and liquidity.

The most convenient vehicles: Treasury-only money market funds like American Century's Capital Preservation Fund, U.S. Global's U.S. Treasury Securities Cash Fund.

Third, consider a stake in the strongest foreign currencies. Remember: The epicenter of the mortgage meltdown is in the United States. So the biggest negative impact is going to be on the dollar and dollar-denominated investments, as foreign currencies rise.

Fourth, for vulnerable investments that you may still be holding, buy hedges that can help protect you against losses. Just make sure they're traded on major exchanges — as are the specialized ETFs designed to go UP when the markets go DOWN.

For example, look at the long menu of inverse ETFs offered by ProFunds. Then pick the ones that most closely match the assets you want to protect.

Fifth, consult with a registered professional advisor. They're the only ones who can help you tailor your strategies to your individual needs, goals and tolerance for risk.

Good luck and God bless!

Martin




© 2007 Martin D. Weiss, Ph.D.
Editorial Archive

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15430 Endeavour Drive
Jupiter, FL 33478
Email | Website

I've read most, for several months.

I am not trying to suggest that this is not a problem, but - frankly - if we can't quantify the scale of the problem consistently, the otherwise solid arguments loose credibility.

The figures I'd like to find at least an accurate estimate for are these:

* Total nominal value of all derivative contracts.
* Total nominal value of all CDS contracts.
* Total net exposure to CDS contracts assuming no bankruptcies
* Total net exposure to CDS contracts assuming bankruptcies only of non-tier-1 banks.

I'd then feel confident that we have an understanding of the scale of the problem, and that we can assess the scale of news as it arrives.

BIS or OCC have these numbers, I think. JP Morgan according to OCC have $7.99 per dollar of capital
Citibank have $4.60 of exposure per dollar of capital.

Good find. That is effing scary. Im not bright enough to find holes in it, but if thats correct, it deserves pinning separately for all new posters to see. Pardon the hyperbole.

If these numbers are known, and there is consensus (even to an accuracy of, say, 20%) I'd love a summary...

No one really knows in reality...but lets just say that some people like Marc Faber and Rogers know with certainty that these banks are carrying a whole load of "garbage" on their books that could take a year or two to clear. I would tend to listen to Marc Faber, he is a genuis and very very well informed.

Forgive my arrogance, but I'm reluctant to accept that someone is a genius on anyone's authority but my own... Sure, I'm an un-trusting kind... but I'm ready to be objective.

At present I have most respect for Mervyn King, who said that there was no likelihood of the systemic failure of sterling - which is what Cgnao is suggesting.

If anyone is to convince me to change my view, it will require hard facts as a basis - conjecture is interesting, but not convincing.

I thought this is it on Sunday too.

Yet it continues.


Quoted from an article on the Russian economic collapse: -

"Its amazing how long a situation that is untenable can continue by sheer inertia"

Numbers here

http://www.noelwatson.com/blog/content/binary/BIS2007.JPG

Can you clarify what you mean when you say "contract is due" please

But are we really talking trillions of exposure for one counterparty if one name defaults. Assume notional outstanding of 45 trillion. There are, according to Markit, around 3000 entities with quotes. Assuming these have approximately the same notional issuance each (oversimplification, but gives us a ballpark figure), we have 0.015 tr or 15 billion per entity. Assuming a recovery of 40%, the protection sellers have to shell out a total of 9 billion if a name defaults. A typically flow desk in a bank will have around 500 names they have risk on. They will be constrained on how much outright exposure they can have on a name, and if a hedge fund wants to deal with them they have to post collateral. If a name defaults and the hedge fund blows up, this collateral is theirs. All calculations above take the 45 trillion exposure and doesn't take into account netting between counterparties.

When Delphi defaulted (with 10 times outstanding notional of CDS than bonds), how many counterparties went under?

What exactly is the exposure? Notional or DV01?

How do they know with certainty? Do they work in all of the banks? If so, aren't they tied by confidentiality agreements?

Even if all contracts 'cancel out', the increase in the size of the CDS market increases the possibility of counter party risk.

And when the figures get to these sorts of numbers...that's an awful lot of counter party risk....which was why I was a bit dubious about Barclays results announcement that proclaimed that they had managed to 'lay off' their risks and therefore had little write off to report (over the reporting period certainly).

Like you, I have quite a lot of respect for the BoE and their pronouncements....which have included:
1. Asking the banks to stress test their systems for a 40% fall in house prices way back
2. Highlighting the risk of the stock market falling
3. Pinpointing firmly the issue of counter party risk.

All very understated - but no less important for that. Unfortunately, perhaps they need to scream a little more sometimes.


Edited: Sorry should have read the rest of the thread...others have also pointed out the counter party risk issue. Oh well.

MAJOR LIQUIDITY PROBLEM IN T-BILLS

Has anyone financially knowledgeable read this thread at Market Ticker, and could you explain the implications?

Bear Holder Lewis May Seek Alternative to JPMorgan Takeover

By Zachary R. Mider and Miles Weiss

March 20 (Bloomberg) -- Billionaire investor Joseph Lewis, the largest shareholder of Bear Stearns Cos., said he may push the company to consider alternatives to the $339 million buyout offer from JPMorgan Chase & Co.

Lewis, a former currencies trader born in an apartment above a pub in London's East End, will take ``whatever action'' he deems necessary to protect his $1.26 billion investment in New York-based Bear Stearns, he said in a filing today with the U.S. Securities and Exchange Commission. He said he may ``encourage'' the firm and ``third parties to consider other strategic transactions.''

100% agree

Does no likelihood just mean unlikely?

"Even if all contracts 'cancel out', the increase in the size of the CDS market increases the possibility of counter party risk."

Are you taking into account the fact that more names may have CDS quoted on them than in the past, and that more people may be trading CDS. If all contracts cancel out, why would there be any counterparty risk?

I cant see how all contracts can cancel out. In the event of an "event" occuring, somebody is going to lose, otherwise, whats the point of all this betting?

After all, the same logic was applied to the loans situation. In the event of this, that would counter, and so on.

This logic is flawed.

I put 'cancel out' in speech marks as that was the terminology used by A.Steve when he was referring to the suggested ability of traders to lay off risks so that if the bet failed, they would win elsewhere. I was actually saying, "even if what you are saying about the cancelling off effect, you are still left with the issue of counter party risk".

I can assure you that a typical flow desk will be more than happy if their net notional for a given entity cancels out. This does not mean to say that their cash flows cancel out as they will hopefully have been buying protection cheaper than they have been selling it. On a counterparty by counterparty basis, the exposure may not net out (i.e. I have bought more protection than I have sold for a given name from a given hedge fund). However, when you consider that all these hedge funds have to post collateral, if an entity goes pop, I can't see my exposure being that big. Maybe I'm missing something obvious

Thats a good policy Steve. Especially in this business. I read his reports and listen to all his interviews, and I have an archive of his stuff. I trade technicals,but use Faber for my fundamental work. I trade in the direction of his and Rogers fundamental outlook. Faber has called the !987 crash, The Asian crash, the Dot com crash and has been talking for 3 years about what would unfold now.

Here is a good recent vdo of an interview with Faber...

Marc Faber

Thanks! Those look credible (well, far more credible than my "vague recollections" from sources without citation, anyway )

We seem to agree, however, that the total notional value outstanding does not paint a particularly accurate picture of the real-world risk - since it is unlikely that all default events will happen simultaneously causing the sum of principle payments to be due from one set of unlucky participants to another set of lucky participants.

I think I grasp hotairmail's objections about counter-party-risk, and this somewhat coincides with my ideas about wanting to find statistics on "net amount outstanding" - since, if we assume that the risk of these CDS contracts has been laid-off (to use betting terminology) then the only real issue is liquidity for participants... (Since CDS contracts may not match up exactly on due dates, principle sums - or insured event.) If there is a real problem, I suspect that this is where it will be found... Of course, I don't imagine that detailed information in this regard is public (I'm sure it would be thought to be a risk to declare such details at any institution - since these details could be exploited by malicious short sellers...) but it would be fascinating to know if broad statistics (in more detail than those above) are available from any credible source.

You mean then that, like Lloyds of London, you hope that the costs of an "event" will be met by a large group of entities?

Then you mention collateral- here is the weakness in the plan.

The date matching may not be such a problem as CDS contracts tend to mature 4 times a year (20th of March, June, Sept, Dec), and as well as the desk having a notional limit esposure per name they will have a limit on each tenor of a given name. The insured event shouldn't be too much of a problem as the vast majority of contracts (in Europe) are traded with modified modfied restructuring.

Note that my experience is limited to sell side, so I can't comment on how hedge funds manage their risk

Fair enough - so - if we assume that the liquidity issue is not severe, then what we need to discover is net exposure then?

I was prompted to think about liquidity by the Goldman Sachs story about them netting $4bn from CDS against which they had no immediate risk exposure of their own... then, a few weeks later, a $3bn uninsured loss.

Interesting dates... if CDS are a major issue, "today" might be the day, then. :-D

And the UK bank chiefs are all meeting today.

And the EuroCentral bank has put out again today (R4 news this morning)

Crunch.

Today is indeed roll day - pricing for single names "rolls down" by 0.25 years. New ITRAXX and CDX indices are released. CPDO sell roll their protection into the new indices.

Have you got a link to the Goldman story - it will be worth a read

I was spouting vague recollections from the top of my head... This is the "win" story:

http://www.independent.co.uk/news/business...ing-765261.html

I can't find a reference to the $3bn loss (which may or may not have been related - just a similar sum, which perked my interest in the context of the above article.) Maybe someone else can find this? I can't recall the date - but it was after the $4 bn story.

What I am saying is that if an entity goes bust, and a counterparty cannot pay up, while a typical sell desk may lose some money, I don't believe it will that big based on the back of a fag packet calcs I did earlier. While the collateral may not make up for all of the loss, it can't hurt. As I said in another thread, I haven't worked in a hedge fund - maybe they manage their risk differently...

Thank you for that, much appreciated.

Ok An individual desk may not lose much, but it is the global effect the failure will have. The ultimate tool for the loss is money, and its that that is in short supply, getting shorter by the day as collateral is revalued to market (well, eventually).

No, I mean something like this:

Tiny company X buys a £1bn CDS against a customer from Trader Y
Broker Y sells a number of CDS including the one to X - and lays of this risk in a combined larger CDS with investment bank Z
Investment bank Z lays off the risk of selling the CDS to the broker by buying CDS cover from hedge funds A & B.

(I've no idea if the participants are credible, or how many steps there are in reality!)

In this scenario, the $1bn will be counted three times - but, assuming the intermediaries do not fall to liquidity issues, the net amount is one third of the notional amount. The broker and the investment bank are not at risk, providing suitable hedge fund collateral is held.

- dup -

lost me there LOL much like the bods at the FSA? could I get a job there?

Anyway, the key for me is the word you use " collateral".

I gather a huge part of this is all based on the toxic asset called a MBS>CDO.

And we all know what they might be worth at the end of the day.

Yes. As they say, a problem shared is a problem multiplied.

The problem is poor families defaulting on loans they can't afford, combined with falling asset values. Anybody in the chain needs to write off their component of losses against capital. Regardless of whether any individual institution fails, the capital available to back lending diminishes. This alone will affect asset values.

But having said that, with all those losses, the risk of a counter party not meeting its obligations rises (as is already starting to take effect with the bond insurers who are for instance being taken to court by Merrill to avoid them wriggling out of their contracts). And once the counter party defaults, clearly the other party who may have been relying on this as a 'cancelling out' trade is then also at risk. What should be remembered, is that it is not an individual contract that would default - but a counter party on all its contracts. You may have limited your direct exposure but you can't limit your indirect exposure. Then again, if a whole class of counterparty goes (e.g. all bond insurers) then that is also bad news.

OK... well... my explanation might not have been very lucid (or accurate) but it's the best I can manage.

At the end of the chain, there will always be someone responsible for the default event... otherwise the CDS are worthless and anyone who has bought one has wasted their money. "My mate Dave" (on the dole with credit card debts and no assets) can't write CDS (i.e. agree to accept loss in the event of the failure of a multinational corporation, for example, in return for monthly payments) - because he has no collateral, and - hence - is not credible. There will be collateral - even if CDS are traded on margins... and before we accept a prophecy of doom based upon the idea that there isn't enough collateral in the world to cover the total nominal amounts outstanding, we need to establish the amount that would actually be required in an absolute worst case scenario.

The CDS I'm discussing is related to corporate debt not mortgage. Don't forget you can get CDOs of corporate CDS. I don't know what is typically being posted as collateral but I will do some digging around

I thought we were discussing *total* CDS - i.e. CDS on all forms of default - be these corporate bonds or asset backed securities.

Did you mean "CDOs of corporate CDS" - if so, can you explain that in more detail, please?

I think that finding out what is posted as collateral would be very interesting indeed.

Is this the one?

http://www.telegraph.co.uk/money/main.jhtm...6/cngold116.xml

That's the badger. I never was very good with history and timescales... I hadn't realised that the "win" was last year and that the loss was last week. How time flies when you're having fun, eh?

I think you're sort of hitting the nail on the head....there was enough collateral (as prices of assets rose)...but there is now not enough to cover all debt on all assets (as asset prices have fallen). (There may be enough collateral in total to cancel out debts...but the debts are not matched up accordingly e.g. recent 100% ltv ftb's are in deep do do...and so are their lenders. )

They estimate what 8m US homeowners in negative equity now. And as for commercial property that is just as bad.

Woah! Time-out!

My understanding of CDS are that they are rather-like a form of insurance against default (only, unlike insurance, you don't require to have the risk to buy the insurance.) The purpose, as I see it, is to make up the difference when bonds representing corporate loans or mortgage debt defaults. While the world is hunky-doory CDS represent bonus income for those willing to take risk. When the world turns dark and people default, the writers of CDS loose.

This is a bit like the Lloyds names... where wealthy individuals posted their castles and collections of sports cars and share portfolios as collateral to underwrite the launching of ships. When there was no disaster they got extra money to play with for doing nothing. When disaster strikes, they loose the lot. Frankly, I don't care much if these people go from dining at the Ivy and eating caviar one month to flipping burgers and shopping at netto the next. I am concerned if there is insufficient collateral for a plausible worst case scenario.

I understand that CDS have been used in conjunction with asset backed securities to produce bonds with a lower risk profile... and that this has allowed greater leverage. This is the issue from my perspective.

The mortgagee's home is an asset - but that is considered at the "asset backed security" stage (CDO) while CDS is applied at a later stage - and kicks in when the owner defaults... entirely separately to the house on which the mortgage is secured.

i think many are with you on this one.

If they could answer it, they could try and solve it.

The first step is to to establish not the total nominal amount outstanding, but the net amount. I.e. the amount excluding intermediaries.

Do you think cutting IRs has any effect on the problem?

I believe in holism... but I don't see any direct connection.

Cutting interest rates, if the interest rate cuts are passed on to consumers and corporate debtors will reduce the likelihood of default... so will reduce the scale of the credible worst case scenario.

If interest rate cuts are not passed on to customers, then they might help banks with access to the central bank recoup their losses after paying out on CDS - if they end up being the liable party.

Wages and profits (i.e. the economy as a whole) will likely have the most impact on the worst case scenario (i.e. number of defaults) - and this will dictate the extent to which the CDS situation has a bearing on the "real world" that ordinary people see.

I agree about the holism- money is disappearing down a big black hole

One thing to note is that AAA counterparties don't have to post collateral - Bear Stearns was AAA!!