Fighting the Fear

Preventing a meltdown in OTC Derivatives

by Michael Hampton, AKA Dr.Bubb | June 5, 2008

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The Problem may be smaller than you think, but that may not Matter. 

"The only thing we have to fear, Is fear itself" - FDR

The coming crisis in credit derivatives, is predictable. Just as the subprime problem was. 

Why aren't the regulators acting now, to prevent the next predictable crisis from fanning out into something far worse? I have no idea. But rather than sitting back, and letting it happen again, I think the time has come for some serious truth-telling. If the global banks, rating agencies, and regulators will not tackle the job themselves, perhaps knowledgeable people with access to the media and the web, can get the facts out, and encourage a sensible course of action. My hope is that, if an understanding of the risks and possible solutions is spread widely enough, then perhaps the authorities will act in time, before it is too late, and the markets start reacting on fear and emotion.

From what I have read, George Soros has taken the job of lead truth-teller upon himself. Using my own deep knowledge of one sector of the derivatives market, I want to help him.

A global financial meltdown is preventable, but only if we start acting soon. Prevention of such a crisis, should be the work of the Fed, other central banks, and the big global banks themselves. But they are not taking the right actions. They may be afraid of undermining already-weak bank share prices, because people would fear that more bad news is coming. They are right to be worried, more bad news is coming. Many of those (like myself) who predicted the subprime crisis and a fall in home prices before they hit, are now predicting a crisis in credit derivatives and other OTC derivatives. Funnily enough, this crisis may be smaller that is feared by some, but that may not matter. If fear takes hold, and spreads widely, it may trigger a financial meltdown - a meltdown that could have been prevented. This article is intended to suggest what the problem is, and what should be done now, to prevent an inevitable crisis from mushrooming into a global financial meltdown.

Fear of the Unknown

The recent experience with subprimes; makes the problem - the lack of an understanding of the magnitude of the risk - very dangerous. Initially, the authorities like the Fed said the subprime problem was "contained." It was not, it got bigger, and bigger, and the writeoffs announced by banks have continued to grow for many months. Writeoffs have spread around the industry, and many banks have been forced to raise new capital, in some cases, several times. Now, banks report the overall size of their subprime exposure, as if it was all bad, and any reduction in the size of their subprime exposures is deemed to be good. I have seen this years ago, during the Latin America debt crisis. At that time; I worked for one of the big global banks, and the market started rating the banks according to the sheer size of the Latin American debt they held, in relation to their capital bases. Since people did not understand the risks very well, they wanted to see the banks get rid of their Latin American exposures entirely. The best banks were thought to be the ones with the least Latin American debt exposure. And so banks took measures then, as they are taking now with subprimes, to manage downwards the size of the exposures. There were writedowns, debt-for-equity swaps, and other efforts, to enable the banks to report reductions in the size of their exposures to those risks.

Now here's my concern: the markets may soon turn their attention to the size of bank exposures to OTC derivatives. If they do, they are sure to be worried. The size of bank OTC derivatives exposures is massive - many, many times the capital base of the big global banks. If this type of exposure becomes tainted, the sheer size of the problem may make the banks that were once looked upon as "too big to fail", suddenly appear "too big to save." Investors who have been willing to recapitalise banks so far; may run for the hills, and decide they cannot put in any more money into the banking sector. And there is a risk that the global financial system could meltdown, as credit-starved institutions stop trading with each other, paralyzed by fear. 

This need not happen. Such a meltdown is preventable. The problem of OTC derivatives may actually be SMALLER than many fear, with core risks far less than is widely reported. But will the markets believe the authorities, after they have seen the subprime problems mushroom far beyond what they were told to expect? I fear not. I think banks should be making pre-emptive efforts NOW to reduce their OTC derivatives exposures. This can be done. This should be done. But it requires a sense of urgency, some innovation in the futures market, and solid explanations in the media about what is happening, and why it is happening. I have been waiting too long for the banks to start saving themselves, so the time has come to provide an independent diagnosis; and some possible remedies.

]Understanding the problem - to whom should we listen ?

Part of the problem is that the Fed would rather deal with this emerging problem behind closed doors. They are worried that if it pops out into the open, fears will grow, and that would make it even more difficult to calm the markets and solve the problem in a way that suits those who own and control the Fed. So the Fed is acting mostly on its own, without the full firepower that the problem may require. But it is not too late for others to act. And George Soros has already spoken about a key part of the solution.

SHOULD WE listen to Soros, or let the Fed and big American banks make all the key decisions ?

What if they are too slow in addressing the underlying problems? And they fail to sustain confidence?

George Soros is a billionaire legendary investor and trader because he looks past the headlines, and the media buzz, to see the deeper issues, and the more profound forces at work. He is worried, and is giving interviews to discuss his concerns. and has even written a new book, The New Paradigm for Financial Markets: The Credit Crisis of 2008 and What It Means. To my ears, he seems to be one of the few people these days who is really speaking sense about certain big issues that are critical to the future of the global financial system. Before turning to possible remedies, let me try to outline the GLOBAL FINANCIAL PROBLEM as I see it. This summary is heavily influenced by the comments of Mr. Soros, who has been talking about a super-bubble in the markets:

+ The global financial system is dangerously imbalanced. The US (and a few other western countries) have gone on a massive spending orgy over the past decade or so, with too much consumer spending, too much property investment, and an expensive war. That spending has been financed by debt, mostly denominated in dollars. The debt was provided by governments (like China, Japan, and oil surplus countries in the Middle East), and by big banks, which had dollars from their depositors to invest.

+ The debt was allowed to pile up, because its providers felt comfortable - many had security in mortgages on property, and their security was rising in value. (Note: the mechanism for recycling dollars shown above was the "Greenspan's Money Machine" that I discussed in my Oct.2005 article for FS.) Low interest rates from Mr. Greenspan allowed the growth of a monumental real estate bubble. When it was easy to borrow 80, 90 or even 100 percent against rising house prices, and banks were aggressively financing speculative home purchases, prices responded, moving upwards. Real estate prices shot up to way beyond what could be justified by rental yields, or cash flows, because buyers were prepared to speculate on continued rises in capital values. So property prices went up too far, creating a classic asset bubble, and rising until prices peaked in mid-2006 or so. Now home prices are correcting, and much of the excessive debt that was created in the imprudent "good times" is being written down, to reflect falling collateral values. Sadly, fundamentals suggest the correction has many months (or even years) to go. There is still a huge supply of new and secondhand homes for sale, and mortgage default rates are rising, suggesting that when future foreclosures happen, they will bring even more supply into an glutted housing market.

+ As Soros has said, markets do not always return to mean equilibrium values. Instead they often can follow a self-reinforcing trend to an extreme. Just as they reached an over-valued extreme when confidence became excessive, they may reach an under-valued extreme if pessimism becomes excessive. Soros believes that actions must be taken by banks and monetary authorities to prevent this. And since we are in a super-bubble with price extremes in many areas, care must be taken to assure that multiple crises do not hit several markets at the same time, triggering a global meltdown. As Mr. Soros, has said, "Our civilisation could perish." The risks are the highest since the Great Depression.

+ The subprime mortgage crisis is only the tip of the iceberg. $1 trillion or so may be lost on bad mortgage loans, and only a portion of this loss has been recognised so far. More losses will be taken on Alt-A and Prime loans, and maybe those writeoffs will be shared by a wider range of banks and investors around the world. But the bigger problem is the knock-on effect on the rest of the system: credit is tightening, asset prices are falling, and other types of bank debt are beginning to look shaky. Loan write-offs may soon spread to the corporate sector, as the recession hits. And confidence in the banking system has eroded.

+ Meantime, consumers are cutting back on their spending, so other non-financial companies are finding it difficult to keep growing, and some are experiencing losses, and shedding jobs in areas beyond the finance, insurance, and building sectors. Many jobs will be lost, putting further pressure on homeowners. 

NOW it is good time to introduce an important word, TRUST. The big mortgage bond losses, in the once "safe" world of Triple-A rated bonds, have destroyed confidence in the integrity of rating agencies, and in the balance sheets of the banks. Trust is a precious commodity; and as the banks are discovering, it is not a quick and easy thing to win back, once it has been lost. The cost of this loss of trust is high, and the banks are paying it through: increased capital costs (on the fresh equity they are raising to replenish their losses), and in higher Libor rates they are paying for their short term debt. Not only that, the banks have lost confidence in each other, because they are not sure how badly other banks were hit. 

it is very difficult to assess true losses in the non-transparent world of mortgage-backed securities. So in a uncertain environment, banks and investors are merely counting the size of their aggregate subprime exposures, without having a good grip on the realisable values of these securities. Those banks that have reduced or written off much of their subprime assets, are deemed to be in better shape than banks which still have bigger subprime exposures, without any clarity about the ultimate collectability of those individual debts. [b] There is a good probability that these securities will keep falling in value, and the riskiness of these assets will be overstated before the mess is cleared. In fact, we may have reached that point already.[/b] But it is hard to assess valuations without a better understanding of the what true risks are imbedded in these non-transparent securities. Meanwhile, the market is very nervous, and so many observers are alert for the next area of trouble. As one commentator put it, "if we are in the sixth or seventh inning of the subprime mess, then it is likely to be a double-header." 

A popular candidate for the next big problem, is the Over-the-Counter derivatives books of the banks. Many articles have been written about how huge these exposures are, and how losses in this area may trigger a meltdown in the global financial system. It could happen, but if it did, it might simply occur because fear spins out of control, and the fear of doing bad business prevents the banks from doing any business at all. A frozen financial sector would create huge problems for the US and for the global economy, and may even trigger a depression. But it need not happen. As Franklin Delano Roosevelt once put it in the depths of the 1930's depression, "The only thing we have to fear, is fear itself." Panic can be avoided, provided the risks are better understood and risk exposures better managed.

In his new book, George Soros talks about how there has been too much confidence put in the so-called self-regulating mechanism of markets. Soros points out that markets do not automatically self-correct to mean values. Instead, markets have a propensity for extremes, or "fat tail distributions" as market statisticians put it. Just as markets ran up to excessive "bubble" levels when left alone, with greed reinforcing confidence, they can fall to excessively low levels, if fear reinforces uncertainty. Soros has some ideas about how to avoid that unhappy extreme. In the section towards the end of this article, I have borrowed his idea of moving risks from the OTC market into traded futures markets, while adding some fresh ideas of my own.

Risk on OTC Derivatives is not easy to extinguish, and gets over-counted

+ The over-the-counter derivatives market is vulnerable (see sidebar on OTC Derivatives, below) , and is seen as the likely vector through which credit problems could spread rapid-fire, right through the whole banking system. But the real risks in these OTC trades are not well-understood in the articles in the popular press. Frankly, the size of the risks are often miscounted and may be overstated and exaggerated by the mainstream press.

This happens because undertanding the true risks requires diving into a level of detail which is deeper than most journalists, or the average readers of such articles, find comfortable. I do look into some detail in the sidebar, and am able to do so, because I once worked for a big bank, and was a pioneer in creating the oil swaps business. With this background, I have a reasonable grasp of how these derivatives work, and how the risks are measured. To summarise what is in the sidebar: the usual risk calculations for the size of the market are inflated, because the risk on Over-the-Counter (OTC) derivatives is not so easy to extinguish (i.e. close off) as they are for exchange traded derivatives. In a sentence, when the core price risk in the derivative may get traded off to other parties, the credit risk normally remains. There are different counterparties on both sides of a trade, so when the market risk is passed to another party, it is through a brand new contract, usually with different counterparties. The entire risk is not extinguished, so it stays on the books. Banks normally carry these risks until the maturity of the OTC derivatives contract, and the final settlement has been made. We can compare this reporting of positions with exchange-traded instruments: where all the risk is extinguished when the position is sold on. The key point is this: I believe the huge numbers for OTC derivatives risk that get reported for on the books of banks can be exaggerated. These big totals are mostly "residual" credit exposures, which can be calculated, and netted out, leaving a much. much smaller net credit exposure on the net loss amount due. In other words, the banks will never have to pay the full amount of the OTC derivatives exposure they report. If the same trades had been done on an exchange, the reported open risk would be far, far smaller.

Now here's where the threat of out-of-control fear becomes an issue. Suppose a major OTC derivatives player went bust, as Bear Stearns threatened to do in March. That would trigger an early forced-settlement of all those still unexpired OTC derivatives trades. In a mass default, various unhelpful and disruptive actions would be taken by parties aiming to protect their positions, and/or benefit from the chaos:

- First, stronger counterparties would exploit the default mechanism used to determine the size of losses. They would close-off trades, using trade prices which are favorable to the defaulted-upon party. The difference between the two sides of a hedged trade might be huge; since many of these derivatives are in illiquid and non-transparent markets. There would be a long and bitter fight about how much each party is actually owed, and how much the bankrupt party can afford to pay.

- Second, where a defaulted trade is a cornerstone hedge in the book of a counterparty, the default would leave the counterparty with a need to replace the lost trade with a similar trade with another "stronger" counterparty. A sudden influx of these "risk unwind trades" might unbalance the market in one direction or another, prompting a big price move. A good example was when Bear Stearns "hit the wall" in mid-March. There was a big drop of over $100 in a few days in the gold price. Many believe this came about because Bear was forced to quickly unwind a big long position in Gold. Those that were aware of Bear's big gold positions stood aside, and let the price drop as the unwinding trades were done, since they did not want to "get in the way of a desperate seller". Others may have made money by anticipating the drop, and going short gold.

- Third, a default by a major counterparty would trigger fears that more defaults are coming, and that the losses and price gyrations might trigger another bankruptcy. Most banks would be very unlikely to enter new trades unless prices were very favorable, or "in the right direction" to reduce risks. This means that there would be a big freeze up in the liquidity of the OTC derivatives markets, just as there has been already in the credit markets. With so many cross positions, this would leave many banks highly vulnerable at a time when the initial bankruptcy may wipe out important hedge trades.

With these possible risks in mind, I think it is apparent that:

+ The "Bear Stearns Bailout" was not really a bailout of Bear, it was a bailout of JP Morgan Chase. A Bear Stearns bankruptcy would have triggered a meltdown in the OTC derivatives market, and the would have led to a crisis and meltdown in OTC derivatives. JP Morgan has one of the largest derivatives books (along with Citigroup), and a suddenly bankruptcy wiping out the Bear Stearns derivatives book would have created an enormous problem for that market, leading to a Gordian knot of defaulted derivatives trades.

+ "Credit rests on trust, and trust has been broken... you don't repair that in a year," risk expert Peter Bernstein has said. In fact, the full extent of the problems in subprimes is still being determined, and credit-related fears are spreading to other financial sectors. What is interesting about the Bear Stearns case is that its capital was eroded through subprime losses, but its actual demise came about because people were fearful of its credit exposures, and its ability to honor its derivatives commitments. Was Bear the last victim of subprimes, or the first victim of an unfolding derivatives crisis?

+ The Fed is too deeply involved to find a solution on its own. (For example, JP Morgan is its largest of 12 Fed shareholders, with 32.35% of its shares. Citigroup owns 20.51%, so between the two, they control over half of the Fed's shares.) And, as many have pointed out, the financial system is global, and fixing the problems may need a global solultion. An even-handed and more "global" regulatory framework, which is really needed here, will only be found when less-compromised parties start getting involved in finding a solution. And if big money from US taxpayers, or foreign countries are going to be involved, it is not right that an entity controlled (or heavily influenced) by a small handful of self-interested American banks is making all the key decisions.

Historical Parallel from 100 years ago: New Regulatory framework needed

There is a historical parallel. In 1907, there was a huge stress on the US banking system, during the so-called "Rich Man's Panic", when a run on the Knickerbocker Trust caused a big slide in the stock market. The fear-triggered meltdown convinced the banks that they need a bigger safety net and larger regulatory mechanism, to shore up markets when they hit times of stress. Eventually, the Federal Reserve was created a few years later in 1913. Almost exactly one hundred years later, we are facing a larger crisis, that has some similar characteristics, but this one is more global in its consequences. For example, we have again seen a run on a big mortgage lending bank. But this time it was Northern Rock in the UK. And Bear Stearns, an 85-year old investment bank has been taken over at a few dollars per share. Trust has been shaken in the regulatory system, and Treasury secretary Paulson has proposed an outline of a new system. 

Investment banks, and hedge funds, accumulate massive leverage; and are huge users of credit, and they also are huge providers of credit. The current framework applies solely to deposit-taking banks; and restricts their leverage. But non-bank providers of credit, investment banks, hedge funds; and off-balance-sheet vehicles of banks, do not have to follow the same set of rules. Some of these entities have been permitted almost infinite leverage. And that unrestricted use of credit has allowed various asset bubbles to develop. The Fed, the Treasury, and George Soros too, are all talking about the need for more regulation, and taking pre-emptive actions to prevent future asset bubbles. Probably investment banks, and some big hedge funds too, will need to be subsumed within a new regulatory framework, perhaps one which is in greater harmony with global market practices. But we cannot wait six years. A quicker fix will be needed to provide a global meltdown, which now looks likely to arise well before 2013.

Actions that should be taken now

Some potential remedies are fairly simple; and can be initiated by banks themselves, without waiting for a new regulatory framework to be put in place. Such as:

]+ Report Net credit positions on OTC derivatives separately from overall positions. If and when a derivatives crisis hits, it will be very useful for the banks to communicate that their net exposures on OTC derivatives are far smaller than the overall book positions that they have been reporting for OTC derivatives. The risk exposures that relate mainly to credit can be easily netted out, leaving a much smaller net credit risk amount, for each counterparty. For example, suppose Bear Stearns had gone bust, and all the major banks had been able to release a report. 

Here's the sort of statement "Bank A" might have made: "We have an overall reportable derivatives exposure of $4 billion to Bear Stearns. But as of last night, this meant a net credit exposure of less $100 million, and in fact, that is the net amount that we owe Bear as of last night." Had several banks quickly released such reports, then a chain reaction of fear would have been prevented. But to get to where they can quickly publish such statements, banks will need to beef up their risk management systems to be in a position to release such reports rapidly, to maintain confidence. They may also have to work on educating media sources, so when such statements are issued they are understood and believed.

+ Establish new futures contracts that are closer in structure to what banks trade in the OTC market.

(I have in mind a specific example, involving oil swaps, a market that I helped to create. A new futures contract could be developed, which settles against monthly average prices, like the OTC oil swaps do. This is a much closer to what banks trade in the OTC oil derivatives market; than the existing Brent or WTI futures contracts.) Banks could then shift important parts of their OTC books into futures contracts, and bring down the mountain of outstanding reported OTC derivatives exposure. This would be done by having the banks agree to "novate" (or replace with new contracts) large existing trades, splitting those old trades into equivalent new trades; where the parties who are long an OTC trade; could instead be assigned (here's an example of a Brent swap being broken into component pieces):

- Futures contracts (in a new WTI swap contract, with settlement mimicking the OTC contracts), - A basis swap (such as a Brent to WTI basis swap), plus - A "difference amount" to be paid by one party, representing the current loss on the trade. 

This could greatly reduce the size of OTC derivatives books. Subsequent losses would then be covered immediately by margin payments through the futures markets, and pricing would become more transparent, since both sides could observe prices traded on the futures market. This step doesn't require more regulation, it merely shifts an important part of bank OTC trading into regulated exchange-traded futures. 

OTC trades were being unwound in the final days of Bear Stearns, since banks were tending to deal only in the direction of risk reduction. But a more systematic shift of large OTC risk positions, into much smaller futures related positions, would be expected to enhance confidence that banks are managing their balance sheet risks effectively, because the "risk mountains" would begin shrinking, and risks would become more transparent.

+ Banks need to take self-regulation more seriously, and give more power to their internal credit and risk controls. This is happening already, and it is a cyclical thing. Once the losses hit, there's normally a power shift from business generation to minimizing risk. The risk areas get listened to more, and new risks are managed more prudently. (I have seen this shift at banks where I have worked in the past, and it is dramatic.) The problem is: it is cyclical. How do you rein in the marketeers when everyone thinks they are making money in pumping out the risky products? That when you need enlightened regulators, and sensible rating agencies. If property prices move in an 18-year cycle, the banks, hedge funds, and rating agencies need to look backwards more than 10 years in doing their historical risk analysis.

+ Some tightening of regulation is needed, for example in mortgage lending. There are two places to look: What documentation is needed for originating a loan. "Liar loans" were a big abuse, and where there is doubt about the borrower's income, maybe tax records could be consulted, otherwise the loan should be looked at as an almost-pure "asset protection loan" where the collateral is the key thing. On loans relying on asset protection, the percentage of advance should normally be much lower, and in such circumstances the banks should have a good independent appraisal. 

Secondly, Loan-to-Value needs to be restricted, particularly when loans are being securitised. I could see it being done like this: 

+ Loan-To-Value (LTV) would be set at a maximum like 65 or 70% for loans that are securitised. 

(Note: this is what is actually done now in Hong Kong, where lending tightened after a 70% drop in property prices from 1997 to 2003. Loans of 70% can be easily securitised, and if banks lend more, they may need to keep the excess on their own books. Result? the banks are more careful with higher LTV loans, and charge more than for normal 70% or less LTV loans.) The reduced LTV cuts the risk on the loan, and may make it "safe" enough to permit it to be securitised, even in today's difficult market environment.

More ideas of this type should be developed. And the banks themselves should be doing this, to help educate the market, and to help calm the market in the event of future disruptions. This is best done early and soon. Because confidence in banks remains fragile, and a minor derivatives crisis should not be allowed to morph into a full-blown financial meltdown. There may not be much time left.

Summary and Conclusions

If a crisis hits, markets may react irrationally. Current reporting, is not clear enough. And because of the nature of OTC derivatives, reports of aggregate OTC exposures may even overstate the actual risk. Unless better reporting is done, it will be easy to mis-comprehend the magnitude of a new problem when it emerges. With the recent experience in the subprime crisis, it seems likely that markets will naturally assume that any early estimate of the size of a Credit derivatives problem, may be too small, and that later as it spreads the losses will get are bigger. This expectation, may serve to spread fears and magnify them, contributing to the vulnerability of the financial system.

The problem is that the OTC derivatives market is so enormous, and problems can spread very quickly through a chain reaction of defaults. The markets may over-react and/or be at risk of freezing up very quickly. Banks that today look "too big to fail", may be deemed "too big to save". Those that can help, like foreign investors who might otherwise be inclined to inject capital, might stand aside because they fear obvious uncertainties.

Eventually, a new regulatory framework seems inevitable. But it will take years to put into place. Meantime, the banks can reduce the size of potential problems, by improving risk controls, and shifting some OTC risks to new exchange traded contracts. Also helpful; would be voluntarily limiting risk exposures (such as loan-to-value ratios) to sensible levels which will not permit future asset bubbles to arise. If these lower limits are sound enough, they may allow securitisation of risks to start-up again.

The next few years will not be easy. Many markets, like housing in the US and UK remain in bubble territory. Those asset values need to be allowed to deflate. But if banks reform themselves and their reporting in a way that helps to maintain confidence, then we may be spared prices moving to a "downside excess", where prices fall below sustainable values, and bring enormous damage to the global financial system.

Copyright © 2008 Michael Hampton
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