There comes a point where in any crisis, one of the principals finally gets around to admitting the actual root of the problem after months and sometimes years of ignoring it publicly. The media finally starts reporting on the real situation because even they have discovered that’s where the real story has been.
We’ve seen a partial chain on this, the media talking about subprime and the credit crisis, as well as the recession and global scope of the problem.
But it appears we’ve finally, finally reached that point in the global financial crisis. For the first time that I’ve seen, people are now openly discussing the Derivative Armageddon in the financial media.
The $62 trillion market for credit derivatives needs regulating to prevent a “calamitous chain” of market failures, Credit Suisse Group’s head of investment banking, Paul Calello, said at the industry’s biggest gathering.
“All sectors of the financial system need to act — both regulators and industry,” Calello told the International Swaps and Derivatives Association conference in Vienna today. “There will be new regulation, and there should be; voluntary efforts are not enough.”
Lawmakers from Treasury Secretary Henry Paulson to U.S. presidential candidate Hillary Clinton have called for tougher standards in a market responsible some of the $245 billion of losses and writedowns on Wall Street. Unlike stocks bought and sold on exchanges, no one knows how much is traded in credit derivatives and who is at the end of transactions.
The amount of credit derivative contracts outstanding almost doubled last year from $34.5 trillion as traders used the market as a cheaper and easier way to speculate on debt than buying bonds and to protect against losses.
Credit-default swaps, traded by banks and securities firms including JPMorgan Chase & Co. and Goldman Sachs Group Inc., are the fastest-growing part of the $454.5 trillion market for over- the-counter derivatives, financial instruments derived from stocks, bonds, loans, currencies and commodities, or linked to specific events like changes in the weather or interest rates.
The hundreds of trillions in OTC derivatives are the endpoint of the crisis. If that market collapses, so does the world economy. Period. The fact that people are even mentioning it, and mentioning that the time to act to regulate it is now is an admission that comes with a price: it shows just how scared the financial community is when it comes to the Derivative Armageddon.
Credit-default swaps, conceived in the 1990s to help banks and their clients hedge against the risk of default, pay sellers an annual premium, usually over five years. Should the company fail to meet its debt obligations, the buyer is paid face value in exchange for the underlying securities or the cash equivalent.
“Derivatives have now reached a sheer scale that clearly could affect the financial system at large,” Calello said. “This new phenomenon of `too interconnected to fail’ is now a permanent part of the financial system.”
If we have gotten to the point where people inside the financial industry are publicly sounding the alarm on derivatives, things are much worse than they appear. Throwing around numbers like $454.5 trillion is something not done lightly when you also mention that a market worth that much is badly under-regulated. It was the public’s blindness to the arcane debt-packaging process that created all these paper trillions in the first place, and now saying that there’s something wrong with something that large is a massive admission.
So why now? Why are people bringing up that the OTC derivatives market needs to be regulated? It most certainly has something to do with part of that market, Credit Default Swaps. And recently, that market has grown out of control.
Credit-default swaps worldwide expanded to cover $62.2 trillion of debt in 2007 as investors rushed to protect against losses triggered by the collapse of the U.S. subprime mortgage market.
Contracts outstanding rose 37 percent in the second half of 2007 from $45.5 trillion in the first half, the New York-based International Swaps and Derivatives Association said today. The market, which has grown from $34.5 trillion in 2006, doubled in each of the previous three years as traders used the derivatives as a cheaper and easier way to invest in corporate debt.
“Trading volume has gone up dramatically,” said David Verschoor, a default swap trader at BNP Paribas SA in Hong Kong. “People are punting it harder than they punt equities.”
Credit derivative trading rose amid the global credit crisis that toppled Bear Stearns Cos., shut down hedge funds and caused more than $245 billion of asset writedowns and losses at the world’s biggest banks and securities firms. The cost to protect corporate bonds from default using contracts on the benchmark Markit CDX North America Investment Grade Index more than quadrupled to a record 198.5 basis points last month from 42 at the end of June, according to London-based CMA Datavision.
The entire derivative doesn’t need to collapse to put the global financial system in the poorhouse. The massive bubble in the CDS market has inflated to over $60 trillion dollars and rising. It has doubled in size in less than two years, which is unsustainable by any measure at that scale. If that bubble bursts as badly as subprime did, the financial damages the world faces will literally be orders of magnitude worse.
Remember, these credit default swaps are basically hyper-leveraged debt. Even small losses in this market can lead to catastrophic problems due to the sheer amount leveraged. If you have a million dollar investment that you’ve leveraged 1000 to 1, and that million dollars goes up 1% in value, you’ve made ten times your investment…which of course you sink into more leverage action.
But lose even a tenth of a percent at that level and your investment is gone completely. It doesn’t even really matter if the bubble bursts…it’s leveraged so high (after all we’re talking about several times the entire GDP of America here) that if it simply stops growing and goes a bit south, the market will completely evaporate.
Losses in a derivative market like this, due to hyper-leveraging, are massively magnified. We’re seeing the Fed bail out financials to the tune of hundreds of billions now just from subprime writeoffs that now stand at a quarter of a trillion dollars. It’s knocked us square into a recession, and a global one at that.
Now imagine the collapse of a $62 trillion dollar market.
Yes, the market gurus and major player are THAT scared.
And keep in mind it will continue to get worse.
The credit-default swap market has become a lesson in being careful what you wish for now that Wall Street has taken $245 billion of losses partly tied to such exotica.
Rather than dispersing risk and lowering borrowing costs as former Federal Reserve Chairman Alan Greenspan predicted, the contracts have exacerbated the debt crisis. What was intended as a way for lenders to protect against defaults spawned a market covering $45 trillion of bonds and loans where no one knows how much is traded and speculators who bet on deteriorating credit quality end up forcing that reality.
Some credit-default indexes have morphed into what Wachovia Corp. analysts led by Glenn Schultz call “Frankenstein’s monster” because they now often drive prices in the so-called cash bond market, rather than the other way around. Fearing a repeat of losses, banks are refusing to support new indexes that would allow investors to wager on everything from auto loans to European mortgages, reining in a market that’s about doubled in size every year for the past decade.
“The indices are just trading on their own account with no relationship whatsoever to an underlying cash market that’s ceased to exist,” Jacques Aigrain, chief executive officer of Zurich-based Swiss Reinsurance Co., said at a March 18 insurance conference in Dubai.
Got that?
The market for CDS is going on sheer inertia. That’s it. That’s the only thing keeping this $62 trillion monster going, sheer inertia.
When reality slows that forward progress down, when the recession becomes that outside force that acts upon market inertia, then things are going to get truly ugly.
If credit default swaps explode, the game ends. And it won’t take much, like the movie “Speed” if the bus goes under 50 MPH, boom. It only has to slow down under the level where the leveraging loss magnification takes hold and starts killing off the market’s players, causing a chain reaction.
If the damage in the markets gets this far, all bets are off. We’re talking financial ruin.
If the financial media is beginning to publicly warn about the possibility of systemic collapse, then it’s a real possibility.
More than ever…
Be prepared.
