Simon Mikhailovich: Financial Derivatives−The Ticking Time Bomb

Jim: Joining me on the program today is Simon Mikhailovich, co-founder of Eidesis Capital. Simon, I want to talk about something you warned investors about going back to 2007, which was the impending collapse of the derivatives market. You had worked in credit derivatives. What did you see developing at the time that gave you that insight and foresight as to the impending dangers of the market which gradually unfolded in 2007 and 2009, and which are, you would argue, still going on today?

Simon: It's definitely still going on today. My firm, Eidesis Capital, has been involved in structured credit since the mid 90s. We have had the opportunity to watch from the front row the development of financial technologies, including CDO, collateralizing debt obligations and derivatives, credit derivatives, and to be more specific, CDS (over the counter credit derivatives). Our understanding of these products led us to the realization that credit derivatives are essentially unreserved insurance…or under-reserved insurance.

Listeners should understand that this is a similar concept to what AIG was doing with subprime mortgages. It was selling insurance against subprime defaults for a very cheap price, because the likelihood of the default was perceived to be minimal. So AIG did not really have reserves to pay claims of subprime default. In any kind of insurance when there are no reserves, it's just a matter of time. In the financial industry it's called a margin call, in the insurance industry it would be a large loss. So as soon as there was a large loss, AIG was not able to pay.

So what we saw in 2007, is that many investment banks were willing to sell insurance (in the credit derivative space it's called protection), against catastrophic defaults of high yields or investment grade credits and investment managers did not have to put up virtually any collateral to either buy or sell that insurance. Imagine an insurance company was selling insurance against a large fire or hurricane without any reserves to pay the claims if the claim actually arose. That's what gave us concern.

So in 2007, we saw that happening and realized it was just a margin call. If there was ever a real loss we would see tremendous cost losses because all these banks have sold each other insurance and they couldn’t really pay if anything ever happened. What we saw was exactly that. That said, what we saw came from one specific area - subprime mortgages. When subprime mortgages experienced real losses (which for insurance would be like a hurricane), AIG, the largest seller of that insurance, essentially collapsed. The government then realized that close to $200 billion dollars of losses would have to be taken by the major investment banks, which would have put all of them out of business. The government realized they needed to make up those losses to prevent massive bank failures - and they did.

The important thing to understand is what happened in 2007 was triggered primarily by subprime mortgages, which is just one segment of the credit markets. These exposures with credit derivatives continue to exist against corporate defaults, both high yield and investment grade, and against sovereign defaults. European sovereign defaults in particular.

The way that banks report exposure risk to their regulators and investors is on a net basis. So if JP Morgan has billions or trillions of dollars exposure to various types of risks, then they go and they buy insurance in the form of credit default swaps on the over-the-counter market from other banks. Then they report that they only have their low exposure minus the protection that they bought from other banks. Other banks do the same thing and they buy protection from JP Morgan.

So they buy protection from each other and report to everybody the net position, but if there's a real loss in the form of Spanish default, or Greek default, or a series of defaults how could they ever pay the losses? That is the concern we have about the system.

There are two implications. One - that the interconnectedness between global financial institutions has never been higher in the history of finance. You can think of CDOs and CDSs as disruptive technologies that have changed the way business is done in finance. They have changed the way that banks inter-depend on each other. This is why we're seeing bailouts - because when nobody can fail, or when one person can fail and cause everybody else to fail, then nobody can fail. If nobody is allowed to fail then the game continues until there's no ability to bail everybody out. That's the end game and that's very disturbing.

Jim: Simon, putting aside the derivative aspects of AIG, the thing that really surprises me is that insurance companies collect premiums for car, home and life insurance and as they collect these premiums, they're required to put reserves aside with those premiums. They have investment accounts so that if an event like hurricane Katrina or Rita hits, they have those reserves to back it up. What are regulators thinking when you have a market globally of $600 trillion dollars with no reserves behind it? It seems like the real reserves are the governments or nations in which these banks reside, and the taxpayers of that country.

Simon: Well that's absolutely right. What were they thinking? They obviously were not thinking, and now it's really too late to think anything because it is what it is. It exists. These exposures exist.

Going back to what I started saying before, which is that all banks report their exposures on net basis, there is no way to now change this game because there are no reserves in the system to post against these potential losses. So if the regulators were actually to demand the reserves be posted, we would find out that many of the institutions are broke or don't have enough capital, by a significant amount. So I can't quite tell you what can be done about it at this point.

Jim: There have been suggestions that the way to do this is to put this on the exchanges, have margin requirements - but if a lot of this was exposed, as you just said, many of these banks would be proven to be insolvent. They are unlikely to do this because it would expose their insolvency.

Simon: Have you noticed that this regulation has gone nowhere for the past three or four years? Well, there's a reason for that. It's not possible to do. If it were possible to put through, then perhaps regulators would have pressed harder. But the banks must have explained to them the potential implications of doing this. I don't know how to quite describe it, but it's an unsustainable situation that continues to be sustained as long as faith in the system continues to exist. It's a faith-based initiative, make no mistake about it.

Jim: Not only is it a faith-based initiative but say I am running an investment banking firm or a division within an investment banking firm and from my sales desk I sell a bunch of derivatives, book premiums, you know … I can take those premiums and book them as profits and pay out bonuses. What’s the incentive to change this?

Simon: Well, that's a very good point, Jim. I refer to this as reverse insurance fraud. It's selling insurance that you know you can never pay if the claim actually happens. So you're absolutely right. There’s a significant set of misguided, personal incentives in retaining the status quo.

Secondly, the entire profitability of the banks is, in large measure, derived from these areas. There are tremendous, tremendous conflicts of interest, and I can tell you that from first-hand experience. Remember, banks claim that they are intermediaries. Goldman Sachs say they serve their clients. But what happens when a trader transacts with clients and sits right next to the prop trader that transactions for the firm?

For example, this situation with JP Morgan. They've accumulated a $100 billion position. I am sure they use their trading desk that is also facilitating credit default swap transactions for the firm's clients, to accumulate these positions. So what kind of fair market is it when the inside trader is accumulating $100 billion positions while the regular trading desk, that supposedly services the clients, knows this and is helping the internal desk build this kind of position - without telling clients about it. I mean, is this a conflict of interest or what?

Jim: You know the other thing that we've seen over the years, going back to Barings and Nick Leeson, to this whale trader at JP Morgan, it seems like as this market has gotten bigger and has exploded (you can count the key players on two hands), these guys on a desk take oversized positions. You would think, Simon, that there would be some kind of risk oversight and it's my understanding the risk manager resigned. But if I was a risk manager overseeing the desk and I’m saying, “wait a minute, you've got this guy over here that's taking an unusually large position,” it should’ve raised an alarm. We know what happened with Long Term Capital Management or the hedge fund that took a large position in natural gas trades a couple of years ago, where they, in effect, became the market. So when it came to liquidate or sell, there was nobody to sell to because they were the market.

Simon: That’s what happened to JP Morgan. You know Jim, I mean, one thing that's important to understand, it's a little bit technical what I’m about to say, but it's important to understand. The way some of these positions are put on, they're put on as risk neutral trades. In other words, there is a long and a short, but the problem is that these derivatives, or this market, is quite inefficient. What happened in the case of JP Morgan is they had a position and they expressed a certain view and at some point it started going against them. They tried to hedge it. As this type of a position goes against you and as you keep trying to hedge it, you have to get bigger and bigger and bigger. In other words, you have to keep putting up off-setting positions that are larger and larger to make up for the fact that the correlations that they believed existed were not really working.

Because there were no reserves, in the normal market it could only go so far, because at some point you just run out of money. But if you don't have to put up reserves, you could get to $100 billion. That is the huge danger in this market - because there are no reserves, or there are very few reserves, the practical check on ability of a trader or hedge fund doesn’t exist. In this scenario anybody can be put in an extraordinarily large position that potentially is market threatening or systemically threatening. There's nothing to stop it, except for management wanting to know about it.

There are no physical limitations, and when I say that these are disruptive technologies this is exactly what I’m talking about. You couldn't take 100 times leverage in the old days because there was no mechanism for that.

Jim: So when you get in a situation like this Simon, where you're supposed to be in net neutral positions (going long but hedging it with a short), but you know the guy you just did your short with has no reserves backing up that short, what makes you believe that your insurance policy is going to pay off? I mean, don't these guys realize this, or do they just simply overlook it?

Simon: Jim, it's a faith based initiative. That's what this whole market is. There's a belief, which was unfortunately enstilled in 2008, that government stands behind these large systemically important institutions and that they are “money good”, no matter what happens. That is what moral hazard is all about and this is where we are reaping what we sewed.

Jim: Let's talk about what stands behind this which is, let’s say, governments, central banks, and the taxpayer. We have been going through, what some have described as an orderly deleveraging process. But as we've seen, whether it's QE1 or QE2, there seems to be less impact with each new round of quantitative easing. I think you referred to it as kind of like antibiotics - eventually the effectiveness wears off over time.

Simon: Yeah, that's absolutely true. We're seeing it right now, This deleveraging has been going on for four years. What people are focused on is, if you think in terms of the balance sheet and income statements, is the beneficial, or benign impact on the income statement and also fairness in conducting the leveraging. What they are not focused on is the cost to the balance sheet of what is going on. The US government is taking on massive additional debts that are staying there, in order to facilitate what everybody perceives to be an orderly deleveraging. But the second order effect is the unintended consequences of borrowing this much money. This is essentially the kind of money that can never be repaid and this is somehow overlooked. 

There is some understanding or some belief on the part of many people that there is no natural limit to how much money one can borrow. But I think that's defying the laws of physics. We have been successfully defying the laws of physics and it's getting harder and harder to continue. So yes, the government is operating under diminishing returns, if you will. We are very concerned that this game is going to end. It will have to end. We just don't know when and how it ends, but it has to end.

Jim: One thing that you point to and we've seen, certainly since the credit crisis of 2008, as a result of government intervention in the market, is inter-connectivity of all these markets. Whether it's the global intervention by central banks we had last November or the currency swaps, a result of that we've seen is what I call the RORO trade, the risk on/risk off trade. When the central banks intervene, the risk on trade comes on, and in all markets the risk goes up, and the stock markets go up. US stock markets, commodities, the risk on trade, everything goes up. Likewise, when the risk-on trade comes off then you see the movement in sovereign spreads, you see German bond yields at record low levels and the US, Netherland and Switzerland debt change. Conversely, with some of the more endangered countries like Greece and Portugal the debt went up.

Eventually, what we want to find in investors is something that is uncorrelated. It’s the old adage, ‘diversify’, well you know if I’m in stocks and I own US stocks and I own stocks of European companies or Asian companies, if all markets are interconnected, I’m really not that well diversified because if the risk-off trade comes off, I’m getting hit no matter where I’m at.

Simon: What you're describing is you're putting eggs in different baskets and then you find out that all of your baskets are sitting inside one bigger basket which you didn't understand until you stepped back, right?

That is absolutely true and I think what you're describing can be described differently. What you're saying is that central banks have essentially engaged in an effort of central planning through price controls. The price they are controlling are the prices of money and discount rates and these prices are the most important signal in the free market economy. Every single thing that gets valued in the financial market uses capital as a pricing model, which requires you to know the risk free rate, the risk premium. If the risk free rate is manipulated and the risk premium is also manipulated by flooding the markets with liquidity and driving the risk premiums down you have problems. Add to this financial repression depriving savers from safe places instead of obtaining any real return, which drives them into riskier assets (and that also drives down the risk premium on risky assets), then that is what is creating even more of these problems. These result in massive cost correlation on all assets and one wants to step back and say, what is it that the central bank cannot print?

Then of course, you go into the world of hard assets that are not financial. These do not have counterparties, and counterparty risk, and their prices on a real time basis may also be correlated to financial assets because of the liquidity flows. Their value is not necessarily correlated to financial assets, because the value of financial assets ultimately is derived from the ability of the counterparty to meet its obligations. That potential is not there despite the high price from these assets.

Jim: Well listen Simon, as we close, if our listeners would like to find out more about Eidesis Capital, how could they do so, please?

Simon: Absolutely, they can visit us at our website, which is www.EidesisCapital.com or they can follow me on Twitter, which is S_ Mihailovich. It's on the website. Actually, there is a link on the website. There's also an email address on the website where they can inquire and ask for information.

Jim: Well, we appreciate you, Simon, joining us on the program. Interesting conversation and certainly I agree with much of what we have talked about this morning. You just can't have a $600 trillion derivative market that has no capital or funding behind it without some kind of future event unfolding. I’m in your camp and believe that this JP Morgan trade is just the tip of the iceberg, that sooner or later something bigger is going to happen here and the way to defend oneself is to own a tangible asset that nobody can default on.

We've been speaking with Simon Mikhailovich from Eidesis Capital. Simon, I want to thank you for joining us on the Financial Sense News Hour.

Simon: Thank you very much.