DrD ADDITION
August 26, 2005
Too little, too late?
nakedshorts.typepad.com/nakedshorts/2005/08/too_little_too_.htmlNY Fed’s meeting to address systemic threats
Firetruck_2The credit derivatives market is a pressure cooker with a rusty latch. The cooks are napping on the couch, sherry in hand, and dinner will be all over the kitchen ceiling unless someone manages to turn down the gas. Quickly.
Slack summer markets tend to do what they want for no reason at all. But the talking heads and chiclet teeth (© Stephen Vita) on Tout TV need a reason for every ripple. So news that the Federal Reserve Bank of New York had called a meeting of top Wall Street firms to discuss the looming train wreck practices in the credit derivatives market copped a large chunk of the blame for Tuesday's late-day stock market dip.
Something’s up, the market said, with the May GM-Ford ratings cut fallout still within its collective memory, and for that reason – or not – proceeded to blow 50-some Dow points into the ether. Something is most definitely up, but the Sep-15 NY Fed meeting is only the problem because it’s too little, and possibly too late.
Wednesday’s market reaction was predictable because of the manner in which the information came out. NY Fed president Timothy Geithner, who sent letters to executives at 14 dealers inviting them to discuss “a range of issues in the credit derivatives market,” in a truly boneheaded move – or a calculated step to garner attention – did not issue a press release.
Instead, word leaked – surprise! – and it took an hour or so for the context, more or less, to come out.
One piece of context is Sep-15, which indicates the Fed isn’t yet sufficiently concerned to interrupt anybody’s vacation. And the other context is that it’s a consultation meeting – not a “lock them in a room and bang their heads together until they sort this out” meeting of the so far – note, so far – unique kind that took place in Sep-1998 when Long-Term Capital Management did its so far – note, so far – uniquely spectacular disappearing act.
The Fed has not named the invitees - “Round up the usual suspects” (Bear Stearns, Citibank, Goldman Sachs, Lehman Bros, JPMorgan Chase, and Morgan Stanley prominent among them) - although it did admit to asking regulators from the UK, France (which would probably mean invites for BNP Paribas and SocGen), and Germany (likewise Deutsche and either/both Commerzbank or Dresdener) to attend.
The bigger context, however, is that the credit derivatives and the closely-related structured finance markets are a pressure cooker with a rusty latch. The cooks are napping on the couch, sherry glasses in hand, and dinner is going to be spread all over the kitchen ceiling unless someone manages to turn down gas.
According to the International Swaps & Derivatives Association (ISDA), credit derivatives contracts – principally CDSs (credit default swaps) – grew from $919 billion to $8.4 trillion over the last three years, a rate that would embarrass Sergey Brin and Larry Page. But at least Google’s co-founders seem to know what they’re doing.
Growth, per se, is not an issue. Derivatives, per se, are not an issue. Credit derivatives, per se, are not an issue. Structured finance, per se, is not an issue.
The issue is a growing body of evidence suggesting that, as child-like as Google’s founders can sometimes seem, those responsible for the growth of the credit derivatives market are, despite numerous warnings, acting with childish irresponsibility.
Unrelated events
The first signs of growing concern came in late February with two apparently unrelated events on opposite sides of the Atlantic. In New York, the Fed announced the revival of the Counterparty Risk Management Policy Group – originally formed to oversee the more-or-less orderly evaporation of LTCM – headed by E. Gerald Corrigan, past president of the New York Fed, and now a managing director at Goldman Sachs.
Corrigan’s explanation for the group’s recall, reported in The Wall Street Journal on Feb-25, sounded kindly. “We agreed it was a good time to take soundings and try to shape events given the relatively benign financial environment. At some point credit spreads will widen…And we need to think about the consequences," he said.
Less benign is the underlying that no Fed tightening cycle, clearly telegraphed or not, has ever been accomplished without taking out at least one highly-leveraged institution, be it Granite Capital, Continental Illinois, or Penn Central.
Meanwhile, in London, the Financial Services Authority wrote to financial institutions active in the credit derivative markets complaining about the “high level of unsigned confirmations outstanding between counterparties for OTC credit derivatives with, in certain cases, transactions remaining unconfirmed for months.”
It also criticized communications in the settlement process, focusing on “financial institutions originating structured debt with a related derivative” that don’t communicate rate or index determinations to payment agents in a timely manner so “custodians and investors may in turn be notified of impending cash movements.”
Hmmm. Unsigned confirmations, possibly months old? Parties not communicating information about who gets paid, when? Way to run an $8.4 trillion business, no?
May showers
The first small taste of what might be came in May, when – unsurprisingly – the credit agencies downgraded the debt of Ford and General Motors. A number of hedge funds and investment banks took substantial losses on credit derivative trades, with London-based GLG’s Credit Fund dropping 14.5% that month, although it is unclear whether all that went in one trade.
As I wrote in a commentary published in the July 2005 issue of MAR/Hedge, “GLG, in somewhat more elegant phrasing, admitted that its pricing models made a complete bollocks of predicting how bond values would move on the …downgrades. GLG blamed the model's shortcoming on the fact that this CDO market had only traded since last year, and that “consequently any risk simulations based on historic data would not have identified” what it characterized as an eight standard-deviation move.”
Putting aside the issue of whether downgrading funky US automakers is common sense, or an eight standard-deviation move, GLG’s explanation provided real evidence for regulators’ concerns that the complexity, and relative novelty, of these instruments raised the possibility of hidden dangers.
May’s events amounted to what the Counterparty Risk Management Policy Group II, in its first report on July 27, described as a financial disturbance, as distinct from “systemic or potentially systemic financial shocks.” But that report devoted considerable attention to the potential for credit-related events to trigger financial stocks. “Credit risk, and in particular counterparty credit risk, is probably the single most important variable in determining whether, and with what speed, financial disturbances become financial shocks with potential systemic traits.”
That report, to which the upcoming New York Fed meeting is undoubtedly a response, made clear – in suitably restrained bureaucratic language – the level of childish irresponsibility at work in the credit derivatives and structured finance markets. Some points of particular note:
* While the report nowhere directly states that market participants may not completely understand all the characteristics of the products they are buying or selling, that is certainly implied by references and recommendations throughout the report. It calls for enhanced transparency, and establishes a number of guiding principles intended to ensure the client understands the transaction and its risks and opportunities.
* Market participants do not have fully-developed credit exposure systems, and are likely to stay behind the curve given the continued development of more complex products. Models rely on underlying assumptions, including market risk factors, that are susceptible to underestimating risk in apparently benign market conditions. [Hello, GLG et al]. Oh, and when “similar risk management models are used across institutions,” [Can you say VaR?] pro-cyclical systemic issues [major blow-ups] can ensue when multiple counterparties react to a market shock in a similar manner. (Pages 51-52).
* While financial intermediaries continue to request initial margin for most leveraged counterparties, not all clients post margin for all transactions. Margin terms have generally tended to become more competitive…almost invariably resulting in counterparties posting less margin…also providing the potential for counterparties to increase leverage. (Pages 53-54).
* Dramatically increased derivatives, and especially credit derivatives, trading volume has prevented many confirmations from being processed, reviewed and signed promptly, and has led to a significant industry-wide backlog of unsigned confirmations. (Page 74).
* Most standard OTC derivatives documents require prior written consent of the counterparty before a transaction is assigned. However “trade assignments may account for as much as 40% of current CDS trade volumes,” and routinely occur without prior written consent. Some assignments occur prior to the confirmation of the trade by the original parties, “thereby increasing the risk of potential disputes with respect to the status and the terms of a transaction.” (Page 115). [Old, and now hopefully anachronistic joke, passed to rewrite for updating: What’s the fastest game in the world? Pass the parcel in a Belfast pub.]*
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So, to summarize: We are talking about financial products that participants on both sides of the transaction may not fully understand. The buyer may or may not have actually posted margin. The deal may have been done, although it hasn’t been documented, or if it has been documented, it hasn’t been signed. Oh, and the buyer has already flogged it off to somebody else who may or may not be acceptable to the seller. And I haven't even mentioned the valuation thing. Childish irresponsibility? It’s certainly getting close.
In a world of bond market conundrums, that sounds to me like a recipe for a re-run of those moments in history when new, fast-growing, leveraged, interest-rate sensitive and largely untested, derivatives are conspicuously present at the center of a potentially-systemic train wreck. Not because they were derivatives, but because their owners didn't understand them.
Seems like a good time for a meeting. When we all get back from the beach.
Related reading
Toward Greater Financial Stability: A Private Sector Perspective
Report of the Counterparty Risk Management Policy Group II
[This report is long, and in parts, dense; but I would strongly recommend that anybody with an interest in financial markets in general, and derivatives in particular, take the time].
Where are the risks?
PMW Tucker, Executive Director, Monetary Policy Committee, Bank of England
[Quote of note: The structured credit market was reminded [in May] that credit risk has a major idiosyncratic element; that even the most sophisticated statistical models can be found wanting when they are detached from fundamentals and/or based on short runs of data; that hedging can hurt when a trade is ‘crowded’; and that, in such circumstances, volatility can suddenly spike and spreads move in unplanned-for ways.] Yup, it needed a reminder.
Loss of momentum in credit markets
BIS 75th Annual Report – June 2005; Chapter VII Financial markets
[If you can't sleep after those other two, this'll do it.]
Dr.D
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