The Grand Banks lies right in the pathway of some of the worst storm tracks in the Atlantic. Low-pressure systems form off the Great Lakes and swoop down off the Canadian Shield and are carried by the jet stream out to sea. Weather fronts travel from west-to-east carried by the jet stream. Slow undulations develop between the two borders. Eventually undulations become more pronounced and separate from the warm air. As this takes place, the air begins to spin and is sucked in towards a center, forming a system that eventually turns into a storm. The Grand Banks was the spawning ground for "The Perfect Storm" in the fall of 1991. Ranked as an honorable mention in the Storms of the Century, wave heights were recorded as high as one hundred feet – a wave height that few people on earth have ever seen. Sable Island data buoys recorded wind speeds over 120 knots registering the storm as a Force 12 on the Beaufort Wind Scale.

I.  FINANCIAL STAGE SET FOR A PERFECT FINANCIAL STORM

The Perfect Storm was one of those rare events that seldom occur or are seen in one's lifetime. Such a possibility now exists on our financial front. Instead of the Grand Banks, there is New York City – home to some of the worst financial storms of the century. A deflationary cold front is gathering force as the byproduct of a credit-induced, high-pressure system ready to burst. Coming off the power center located in Washington, a low-pressure inflationary hurricane has been slowly gathering force over the last eight years. It is the product of taxation, regulation, financial market manipulation, the suppression of gold and silver prices, under investment in key resources, trade deficits and a surfeit of dollars. As a result of the expanded money supply and its revenues, the tax system has been evaporating dollars out of the economy. The two storm fronts are about to collide.  Hovering above is the jet stream, which is the international monetary system, a huge interbank market that moves trillions of dollars of currencies around the world.

All that is needed is a trigger mechanism to shift the jet stream off its intended course and move the two storm fronts towards collision. Financial weather centers in New York, Washington, London, Frankfurt, Paris and Tokyo are monitoring the storm's progress. Financial meteorologists disagree as to the outcome and the direction of the storm, but they all know it’s out there. Some say it will be deflationary because of the credit-induced cold front. Others say it will be inflationary because of the energy force created by the expansion of dollars throughout the monetary system. Perhaps it will be both or something entirely different. Perhaps it will be The Perfect Financial Storm. The combination of a high-pressure system meeting up with a hurricane-fortified low could create something we have never seen before: a financial pressure gradient seldom seen by financial meteorologists, the simultaneous occurrence of two different storm fronts – one inflationary, the other deflationary.

At the risk of sounding repetitious, it is important to point out that these storm fronts are indeed gathering force. Wall Street expects a V-shaped recovery and a quick resumption of the bull market. In their view, the current problems have been assessed as nothing more than an inventory correction. However, as pointed out in previous installments, there is more at work here than a simple inventory correction. The problems are systemic. They are the result of a giant credit bubble fed by an expansionary monetary policy. This bubble has led to enormous imbalances within the economy and financial markets. These imbalances are creating the storms. It remains to be seen whether these storm fronts collide and form The Perfect Financial Storm.

The Deflationary Storm Front

Debt, Debt and More Debt Spells Trouble
Meanwhile the expansion of the money supply and concomitant expansion of credit go on unabated. As these graphs indicate, the money supply looks like an F-14 carrier launch. Everything from consumer credit, household mortgage debt, financial sector debt, and total credit debt outstanding are growing at near double-digit rates. Right now financial institutions are creating credit card-backed bonds. Selling the bonds enables financial institutions to sell more debt and turn more of their assets into cash.

These institutions remove the accounts from their books by repackaging them into bonds. Through this process they are able to collect more fees. Getting the loans off their balance sheet also allows the banks to free up additional cash required as reserves against possible loan losses. Large financial organizations such as Citibank and MBNA Corp. have grown their businesses at double-digit rates because of their ability to securitize their loans. Last year these two firms accounted for nearly 45% of the total of $459.3 billion in US credit-card accounts outstanding at the end of 2000. The result is that credit card debt grew by 17.7% since 1999. ¹

The consumer-spending binge cannot go on much longer. Consumer balance sheets continue to deteriorate by burdening debt and shrinking investment portfolios.  More than $4.5 trillion in wealth has been wiped out in the current bear market. This deflationary cold front could gather momentum as it hits the consumer with full force. Confidence is eroding with each 100-point drop in the financial markets and with each day’s announcement of more layoffs coming from corporate America. Debt levels are still expanding and the job sector is still strong, so we have not yet arrived at the point of panic.

A Possible Scenario
However, there comes a time when confidence is replaced by fear and fear is replaced by panic. That panic could induce further asset sales and bring the bear market into its second and most deadly phase where consumers jettison assets to pay down debt. Evaporating confidence causes consumers to retrench on current and future spending plans. Suddenly the economy begins to contract in a deflationary spiral. Injections of new credit are useless. The consumer is tapped out, businesses go under and nobody wants to lend.

Corporate America Showing Signs of Retrenchment
It is obvious that the credit bubble is beginning to burst. Five cuts in interest rates and an expansion of the supply of credit have failed to arrest a falling stock market. Job layoffs have become a daily news event. Corporations warn of profit shortfalls and analysts warn of deteriorating corporate balance sheets. Business stress can be seen everywhere. Air travel has been cutback, cheaper hotels are being used, and durable goods orders are down. Bankruptcy filings by major corporations such as Montgomery Ward, Sunbeam, TWA and Owens Corning are increasing. Junk bond defaults are escalating with a rise of 6.7% during the last twelve months. Recently Moody’s upped its default rate for this year to 9.7%. As more companies file for Chapter 11 bankruptcy, bondholders are getting paid back $.17 on the dollar. ⁴

Consumers Showing Signs of Retrenchment
Stress is also evident at the consumer level. Mortgage delinquencies increased by half a percent to 4.54% during the fourth quarter. Many consumers are carrying mortgages at 95-125% of their home’s value. While interest rates have headed lower, mortgage refinancing should hit $1.5 trillion this year. A consumer that is more willing to go deeper into debt has supported retail sales. But that may be coming to an end with collapsing stock prices. Our local paper in San Diego ran a headline story “Retailers in county wonder where their shoppers went.” Stores reported sales declines in March anywhere from 5.3% to 13.0%.

During a recent trip to my favorite clothier, I asked the manager of the store about business. He told me that week-by-week, over the last six months, that business has been steadily declining. Last year, sales of men’s suits were 48% of the store’s business. This year, suit sales were only 19% of store sales. Suits are high margin. Casual clothes, carrying a smaller margin, have replaced them. He attributed the decline and change in shopper preferences to worries about the job market. Customers are only buying the essentials.

As bank credit standards are tightened, debt-strapped consumers may find it more difficult to find new sources of credit. Bereft of skyrocketing stock appreciation, consumers are using more debt to fund their purchases. Consumers have increased their standard of living by credit spending. This has made banks very rich and families very vulnerable. The average annual percentage rate of credit cards is 15.52%. As more borrowers lose their jobs, they face debt loads they can’t handle. These debt loads threaten their mortgage payments and in many cases, lead to bankruptcy. Bankruptcy filings have increased by 22% during the first quarter of this year, and the delinquency rate on credit cards has risen to 5.3%. ⁵ The savings rate is now negative by over 1%.

Real Estate – The Last Bubble
Real estate is the last beneficiary of the credit bubble. Lower interest rates have allowed existing homeowners to trade up, new owners to buy in, and existing mortgages to be refinanced. However, as the economy slows down, job layoffs increase, and stock market wealth evaporates, housing will be the last bubble to burst. There are already signs that a retrenchment is taking place.

In April, new home sales posted their biggest decline in four years. The sale of single family homes tumbled 9.5%. Existing homes sales are already starting to slow and the rate of growth in new housing has come down. You can observe the subtleties of this slowdown by the increase in houses going on the market in your neighborhood. Where I live, which is Southern California, you have to be a near millionaire, have ample stock options or a six-figure income, or have a banker as a close friend to be able to afford a home. Housing prices can run as high as $250 a foot. Housing, property taxes and increased utility costs are mounting.

One of the untold stories last year was fact that the bubble shifted from the stock market into real estate. It continues today. Non-bank financial intermediaries like Freddie Mae and Freddie Mack are feeding it. Fannie Mae had mortgage volume of $105.6 billion in the first quarter of this year. This compares to $50.8 billion during the same period last year. The mortgage credit balloon is behind the current boom in real estate. However, as these entities continue to expand their balance sheets, they must continue to hedge their interest rate risk. Fannie and Freddie make money on the difference between their cost of borrowing and the yield they receive on mortgages. To maintain that margin, they expand their hedges through derivatives like options and interest rate swaps. The constant swings in the derivative markets have made their earnings less stable. They take a hit in earnings whenever long-term rates go down. This constant need to hedge an expanding balance sheet is forcing them to take on more risk to achieve their earnings objectives. Even Warren Buffett has been dumping his shares of Freddie and Fannie because he believes they have become risky. Aware of this risk, Congress is considering legislation that would transfer oversight of the two agencies to the Federal Reserve.

Deflationary Storm – A Matter of Phases
Once job layoffs begin to accelerate, we will see the price of real estate begin to soften, weaken, and then collapse. Lenders will then have to contend with a growing portfolio of delinquent loans. More real estate will come on the market, which will further soften prices as overburdened consumers unload expensive homes. Mortgage delinquencies will force banks to unload their loan portfolios further dumping supply onto the market and weakening prices. The downturn in real estate, following the collapse in stock prices will initiate the second phase of deflation. Once real estate prices cave in, consumer confidence will ebb to new lows, setting off phase three of deflation, which will be a full-blown recession. The recession will cause manufacturing to cut back, layoffs to accelerate, consumer spending to retrench, and retail sales to contract. This could lead to a shortage of real goods in the economy, which would cause an inflationary storm front to collide with a deflationary storm front in paper and real estate assets.

Inflationary Storm Front

Higher Waves in Raw Materials
While the deflationary storm front wrecks havoc with the economy, a simultaneous inflationary storm front will heat up in raw materials. Years of low prices have evaporated aboveground supplies and capacity in just about every raw material from silver, gold, platinum, palladium, to oil and natural gas. Years of low prices have led to under-investment in everything from new mines, offshore drilling rigs, pipelines, refineries, tankers, to sugar and cacao plantations.

The Energy Crisis Has Just Begun

Higher energy prices are hurting manufacturing by forcing production standstills. The Bonneville Power Administration, a government agency that sells hydroelectric power in Washington, Oregon and Idaho requested that the aluminum companies in the region stop using its power for up to two years. The ten smelters located in this region account for 40% of US aluminum-making capacity. Aluminum prices rose $32 on news of the possible shutdowns. Companies have agreed to shut down smelters to conserve energy. Alcoa and Kaiser have cut more than 1 million metric tons of production because of the energy shortage. The new shutdowns requested by Bonneville Power may result in 6,000 people losing their jobs. Elsewhere, Phelps Dodge is shutting down 11% of its annual production because of high energy costs. Many firms have found it more profitable to sell their electricity than produce raw materials.

Commodities Are On The Move

While we have under-invested in our energy infrastructure, low commodity prices have caused mines to be shut down and plantations to go fallow.  At the same time, with globalization during the 90’s, much of our manufacturing capacity has moved offshore. Mattel is now closing its last manufacturing plant in Kentucky and moving to Mexico. We import more of our basic goods from overseas which accounts for our record trade deficits. This further adds to the inflationary storm front that is building through the monetary system. Since we pay for these imports of consumer goods and energy with dollars, a collapse in the dollar would spell higher prices for basic goods, raw materials and energy. The rise in oil and natural gas prices, aluminum and palladium are signs of inflationary time bombs ready to detonate.

The Monetary Storm Front

International Currency & Confidence in the Dollar Eroding Meanwhile another storm front is brewing in the international currency markets. A falling U.S. stock market and a faltering economy could cause erosion in foreign confidence in the dollar. Throughout the financial turmoil of the 1990’s, the dollar has been a beneficiary of each global crisis: the peso crisis in 1994, Asia in 1997, and Russia in 1998. During each of these storms, foreigners could buy dollar assets as a safe haven and refuge. This served the U.S. well since it allowed us to fund a growing current account deficit. Today this huge current account deficit is unsustainable. A loss in confidence in the U.S. economy and financial markets could cause foreigners to cut back or even dump their dollar-based financial assets. A dumping of the dollar would force bond prices lower, thereby ratcheting up interest rates. Higher interest rates would play havoc with the economy and our financial markets. We Are Whom We Owe As these graphs of foreign holdings of U.S. Treasuries and financial assets indicate, a collapse of the dollar could trigger a simultaneous collision of inflationary and deflationary storm fronts. Whether a collision of these two storm fronts takes place will depend on the jet stream. In the realm of weather, the jet stream is the engine behind all weather fronts. It is a river of cold air circulating around the globe at elevations of thirty to forty thousand feet. In its path lie storms, cold fronts, hurricanes and short-wave troughs that get dragged eastward by this layer of cold upper-level air. The jet stream is unsteady and unpredictable. When, where and why storm fronts occur are beyond the ability of scientists to predict.

Financial Nor’easters Probable
In the financial world, the jet stream is the international monetary system. This market consists of a network of interbanks that move trillions of dollars of currency around the globe on a daily basis. Like the jet stream, it too is unpredictable. The global monetary system, which still runs on dollars and is no longer anchored to gold, is not only unstable but also capable of producing its own equivalent of nor’easters. These nor’easters are financial time bombs that can subject a nation and its financial markets to chronic turmoil. They have touched down in the U.S. in 1987, Mexico in 1994, Asia in 1997, and Russia and again in the U.S. in 1998. They are capable of producing immense destruction. These financial nor’easters can cause currencies to gyrate, interest rates to soar, send domestic economies reeling, and cause stock markets to crash. The jet stream moves money around the globe to various hot spots seeking the highest return. The more money governments create, the more money that is sucked up into the air of the international jet stream, and the more unstable it becomes.

Until recently, the U.S. has remained outside most of the storm paths brought about by this international system. This is because of the advantage the U.S. dollar holds as the world’s reserve currency. It has spared us from experiencing the harsher storms unleashed on Asia, Latin America, and Europe. In fact, in times of turmoil, we have been a refuge for currencies seeking shelter from other storms. Only once in recent memory did it impact the U.S. as seen in the dollar crisis of 1985-87 which led to the October stock market crash of 1987.

Over the last two decades, when a global storm front appeared, money flowed into the U.S.. Today we are now in danger of another dollar crisis. The US is running huge current account deficits with the rest of the world (now 4% of GDP). The massive credit bubble of the Clinton years has caused over-consumption and malinvestments in the U.S. It has also produced a negative savings rate, caused consumer debt loads to balloon, and imports to soar. Not only are we borrowing vast amounts of money domestically, but we are also absorbing much of the savings outside of the U.S. We have had the good fortune of having our trading partners invest our exported dollars back into our country. The danger is that we are consuming our capital assets. We have traded our inheritance for DVDs, stereos, TVs, consumer electronics, and automobiles.

These massive trade deficits have resulted in a transfer of our capital assets – from government debt, corporate bonds, to the ownership of US corporations – into the hands of foreigners. This process can’t go on indefinitely. In fact, if it unwinds, it could bring about The Perfect Financial Storm. In the past a financial crisis favored the U.S.. But unlike the past, we now have massive debt burdens at the consumer and corporate level. We no longer have a high savings rate that can cushion the country in an economic downturn. Our savings has been replaced by credit cards with average balances of $8,000. We don’t have large inventory imbalances. Instead, we have a large overhang of malinvestments in technology.

As mentioned in previous installments in this Storm Series, faith in the dollar is based on faith in our financial system and faith in the U.S. military. These are the intangibles that support the greenback. Should a situation undermine faith in either area, a serious dollar crisis would occur.

I have already identified our Achilles heel in Rogue Wave/Rogue Trader. An unexpected rogue wave hitting this market could lead  to The Perfect Financial Storm.

II.  THE DERIVATIVE TIME BOMB

Ever since the 1987 stock market crash brought derivative instruments to everyone’s attention, the financial system has been buffeted by waves of derivative mishaps. In each case the caldron has been contained. Experts have concluded these crises were liquidity-driven. They believe that when they erupt, they can be contained by a fresh injection of liquidity from central banks. When these catastrophes occur, the Federal Reserve has moved expeditiously to flood the markets. In each calamity the financial markets have bounced back only to see another crisis erupt elsewhere. The Fed fixed the peso and derivative crisis in 1994. It resurfaced again in Russia and in the U.S. in 1998.

Experts have identified four accelerators that must be restrained in any crisis to keep it from escalating. They are leverage, forced selling, momentum mood swings and a loss of confidence. It is widely believed in financial and government circles that if enough liquidity is applied, the collateral damage to the financial system can be minimized. Up to this point each financial maelstrom has been isolated, contained, and prevented from turning into a worldwide contagion. This has bred widespread confidence in the Fed and complacency by the investment community. At the same time it has created a moral hazard in the marketplace. There is a capricious belief that the Fed and other central bankers are capable of bailing out the U.S. or any other nation out of a disaster. Today, while our financial system stands closer to a precipice, confidence in the efficacy of monetary policy is supreme.

The financial community and the investment public readily believe that monetary policy will fix the stock market and avert a recession in the U.S.. Burgeoning debt burdens held by consumers and corporations, a negative savings rate, and a monstrous trade deficit are shallowly ignored by the media and financial press. Everyone believes in a V-shaped recovery or the so-called “soft landing”. The financial bubble is simply ignored. Wall Street believes that an inventory problem is behind our current troubles. Dividend yields of less than 2%, a P/E ratio of 28 for the S&P 500, or a negative P/E for the NASDAQ is irrelevant. There is too much confidence and complacency. That is where the danger lies. When there is this much complacency, it is usually shattered by an unexpected event. I will repeat something that I wrote in Rogue Wave that is relevant to today’s smugness.

There will come a day unlike any other day, an event unlike any other event and a crisis unlike any other crisis. It will emerge out of nowhere at a time no one expects. It will be an event that no one anticipates — a crisis that experts didn’t foresee. It will be an exogenous event — a rogue wave.

The Fuse is Burning

Derivative Exposure Increasing
I believe that a rogue wave is lurking somewhere out there in that arcane world of derivatives. (See Rogue Wave for a complete explanation of derivatives.) The notional value of derivative contracts is now widely believed to exceed $100 trillion dollars worldwide. During the fourth quarter of 2000, derivatives in U.S. commercial bank portfolios increased by $2.2 trillion to $40.5 trillion. Most of that increase was in interest rate contracts. Credit derivatives increased by $47 billion to $426 billion. Equity, commodity, and other contracts grew by $59 billion to $1.08 trillion. Like previous quarters, the bulk of these contracts are concentrated in the seven largest banks. The top seven banks account for $38.9 trillion or 96% of the total notional value of derivatives. One bank, JP Morgan Chase, accounts for 59% of that total. 6

“Netting” Disguises Reality
The netting of contracts can reduce part of the gross exposure of derivative positions. Close to 70% of these contracts have been netted. (Netting limits the exposure of a bank’s obligation, in the event of a default or insolvency of one of the parties, to the net sum of all contracts in the bilateral netting arrangement.) These notional values are a reference value on which contractual payments are derived. The amount of risk in these contracts is related to the bank’s aggregate trading position as well as its asset and liability exposure. Total credit exposure for the top seven banks increased to 254% of risk-based capital from 239% in the third quarter. These top seven banks hold 97.5 percent of their contracts for trading purposes. Banks reported revenue of $405 million from trading positions in the fourth quarter. 7

The problem with derivatives is that the bulk of these contracts (90.2%) are over-the-counter (OTC) contracts. They are preferred because of their customization, but they are less liquid than exchange-traded contracts and expose the banks to greater credit risk. There is always the danger of counter-party risk and the creditworthiness of the parties in each transaction. A bank may take an aggressive position as being long or short in a particular market. In order to mitigate that risk, an opposite hedge may be taken with another party. The problem arises when the institution, which is used to hedge a long or short position, gets into financial difficulties. It may end up defaulting, leaving the other firms long or short position unhedged and naked.

LTCM – A Case In Point
This default danger is amplified as we have seen in the case of Long Term Capital Management. LTCM’s counterparties in their derivative transactions were supposed to be protected by their collateral. However, in reality, as the fund failed, it forced a liquidation of contracts thereby driving down price and evaporating collateral in the process. Long Term’s collapse left the counterparties to their swaps naked and unhedged by the event of LTCM’s bankruptcy. In the end, the extent and magnitude of Long Term’s positions not only put the hedge fund in danger, but it also put Wall Street on the hook as well. Long Term’s failure nearly caused a run on Wall Street. In its final days it was leveraged by more than 100 to 1. All of the big banks and brokerage firms had a stake in LTCM. It took Fed intervention and fourteen banks chipping in to cauterize LTCM’s problems and prevent them from turning into a contagion.

Explosion in Today’s Derivatives

Once again the growth of derivatives is exploding. The figures listed above do not contain the position of major Wall Street investment houses. The very size of these contracts is staggering. The derivative market dwarfs the actual financial markets. This table only includes the top seven banks. It doesn’t include investment banks or derivative holdings worldwide. The total notional value of derivatives worldwide is estimated to be in the range of $100 trillion. Clearly, the markets are leveraged as never before and the size and scope of derivatives have turned our banking system into a large casino. The bulk of these contracts are used for trading purposes and therefore these contracts have become instruments of speculation.

The most frightening aspect of this market is that it continues to expand on top of mishaps such as LTCM. What happened to Long Term is not an isolated event. It came after a decade of misadventures: S&L crisis, Mexico, Asia, and Russia. In spite of each one of these crises, the Fed has taken a laissez faire attitude towards derivatives. It has thwarted efforts to regulate or require fuller disclosure. It continues to allow the banking system to build up its exposure in this market taking the view of intervention rather than prevention. It has, in effect, created a moral hazard by shielding these large institutional investors from the consequences of their mistakes. The result is that the derivative markets continue to mushroom and thereby emboldens investors to make even bigger bets.

The chart on the left is based on values as of 12/31/00. It depicts the U.S. market's largest company, GE, with $475 billion in market cap, to the ever-expanding "Tower of Babel" in derivative assets. The sheer size of comparison should send warning signs worldwide.

The Rhetoric Against Concern
The main argument in support of this speculative market is that LTCM and other derivative calamities are merely isolated cases. They can be avoided by better modeling. If problems erupt to jar the financial system, they can be contained by immediate injections of liquidity. We have experienced these problems before from the stock market crash in 1987 to more recently LTCM and Russia in 1998. In each case, Fed action has contained them. This has given way to complacency and invincibility. Despite each crisis, the derivative market grows larger and more concentrated. This begs the question, At what point does the market become too large and too concentrated where intervention cannot succeed? I believe we are rapidly approaching that point.

The Lure of Leverage in Derivatives
The huge amount of leverage inherent in derivatives allows speculators to magnify their returns. In the case of LTCM, it turned a cash-on-cash return of 1% into a hefty 59% return – all because of leverage. Derivatives give speculators enormous power to enlarge their positions. It gave George Soros the ability to take on the Bank of England and force the country to devalue its currency. It can, as is the case of the precious metals markets, distort the market laws of supply and demand. Silver and gold have been running large supply deficits for many years. Despite silver and gold production deficits over the last decade, the price of both metals has declined. The world of derivatives has allowed large price distortions to occur. It is also been employed in currencies, stock markets, interest rates, and precious metals. The danger derivatives represent can best be illustrated by two examples.

Examples of Danger:  LTCM & Metallgesellscaft

Most readers are familiar with the LTCM story since it nearly brought down our financial markets. But the lessons of LTCM have been forgotten. In fact its main principal, John Meriwether, was back in business fifteen months after the collapse of his hedge fund. Meriwether raised $250 million from his former investors and is busy managing another hedge fund. I’m sure that he is convinced he has better models that will keep him out of danger this time around. The mathematical models developed by his former associate, Myron Scholes, defined risk in terms of volatility. Volatility has replaced leverage as risk. In the process, it has become The Holy Grail of the derivatives market.

The Bell-Shaped Curve Rationale
The models that run derivatives are based on volatility around the mean. They are based on predictable patterns. Patterns emerge in the financial markets and models are developed around them. It is expected that the patterns will remain in force. They should fall under the bell of the bell shaped curve. Markets are expected to remain under this curve with only an occasional deviation. Most models predict that patterns will fall within one or two standard deviations of the curve. If there are abnormalities, they will eventually revert to the mean over time. For the markets to depart from the norm is considered a seismic anomaly.

Blind Faith in "Reversion to the Mean"
Meriwether’s investment strategy was based on the fact that patterns always revert to their mean. Therefore any abnormality in the market would, over time, revert to normal. Thus patterns or events are predictable. This instilled in Meriwether an investment stratagem of riding out losses until they turned into gains. It was blind faith in the concept of reversion to the mean. But markets are never certain. In real life they are always in a state of flux. The trading patterns that make up today’s universe of certainty may change. How do you know what the next pattern will be? The probability of each new trading pattern is independent of the other. One doesn’t remember the other. He believed that mathematics could make an uncertain world certain. Wall Street is completely blind to this fact.

Mathematical models, the certainty of trading patterns within various markets, and the reversion to the mean have become a religion on the Street. Its adherents follow it with blind faith to this day. In the case of LTCM, it eventually led to its demise. The professors and traders at LTCM became convinced of the invincibility of their models. Their bets became bigger and as a result less liquid. For example, in the case of an arbitrage bet on Royal Dutch and Shell Transport, their positions were so large that they became the market, which made them even more vulnerable. Their models didn’t take into account or make allowances for what lies at either end of the tail of the curve. In a short period of time, events at the tail of the curve would overwhelm them. In the fall of 1998, a series of events took place that shook the financial markets. It began with Russia’s debt default which widened credit spreads on debt – something the traders at LTCM hadn’t envisioned. It was followed by conflict with Iraq over weapons inspections. There were rumors that China might devalue exasperating an already fragile situation in Asia, and in Washington the public was introduced to a White House intern named Monica.

As investors fled the Asian and Russian markets, they piled into treasuries and in the process, widened the spread between Treasuries and other debt instruments. Investors were looking for safety. No one wanted risk. While the credit markets tightened, LTCM moved in and loaded up on Russian bonds. They figured that the widening credit spreads would eventually narrow and revert back to the mean. It was a game they had played all too often and won. This time, however, time wasn’t on their side. The Asian crisis in 1997 and Russia in 1998 changed the trading pattern. Investors wanted out of risk. Swap spreads in the credit markets went through the roof. LTCM was fully loaded hoping to make a fortune. Their models gave them no cause for alarm. However, instead of reverting to the mean, credit spreads kept widening. LTCM’s portfolio began to hemorrhage profusely. Losses went from $35 million a day to $553 million on one particular day. The fund began selling out its portfolio, which further exacerbated their losses. Their positions were so large it became too difficult to unwind them. There wasn’t enough liquidity in the market to absorb it.

In the end, the fund would fold, falling victim to the arrogance and hubris of its partners. By ignoring leverage in their models, the fund strictly focused on volatility in its definition of risk. The mathematical models predicted certainty in an uncertain world. To the partners everything fell within one or two standard deviations of the curve. What lay at either end of the tails was a chaotic world the partners chose to ignore. It became their Achilles Heel.

Metallgesellschaft’s Mistake
The German firm, Metallgesellschaft, had repeated many of the same mistakes of LTCM. Back in 1993 a subsidiary of the firm, MGRM in the U.S., made an aggressive move to become a major player in the U.S. oil market. They sold long-term oil contracts to independent dealers at fixed prices. MGRM hoped to make money through arbitrage between the spot oil market and the long-term market for oil. The firm sold contracts of oil to independent dealers at fixed prices going out ten years. These financial maneuvers resulted in a mismatch between supply and demand, making the firm vulnerable to the vicissitudes of the market. MGRM’s customers went long while the firm went short. MGRM covered its position by buying near-term contracts in the futures market and rolling them over each month. This was their undoing. 

Their strategy worked as long as the markets remained in normal backwardation. The firm was selling long-term contracts at higher prices while hedging with short-term prices. However, in 1993, the oil markets reversed into contango. (See graph for visual explanation.) The firm made money as long as the markets remained in normal backwardation. The moment they went into contango, the firm began to lose money. MGRM's traders were betting that the market structure would remain stable and that prices would follow historical patterns. They were also counting on maintaining their hedging practice. The problem arose because in futures markets, losses and gains are immediate. A firm must mark its positions to market. Losses require cash payments to maintain margin. However, gains or losses on delivery contracts appear only at the time of delivery.

The problem for MGRM was that they were covering their long-term commitments with short-term hedges. Their traders made a sophisticated bet that markets in oil would remain in a constant pattern. In other words, the markets they were betting on would fall within the normal probability of the existing state of the market or backwardation. As long as these conditions remained, MGRM made money from the spreads between the expectations of the long and short end of the market.

However, the markets didn’t remain the same. In fact, because MGRM’s short-term hedges were so large, they in effect contributed to the contango. At one point, they made up close to 20% of all open interest outstanding on the NYMEX. By taking such a large position and having to roll it over each month, the firm created its own death warrant. The firm’s position was so large, it began to work against itself. Like vultures swarming to the bloodbath, traders took advantage of MGRM vulnerability. By November of the following year, the firm’s trading losses mounted to $1.75 billion wiping out all of its capital. By February, those losses grew to $2.2 billion. The parent company pulled the plug. Ironically, had the firm enough capital to weather the storm, the markets eventually went back into normal backwardation.

MGRM became a victim of its own circumstances. A large long position contributes to backwardation of the markets. A large net-short position turns the markets into contango. The very size and nature of its position flipped the markets from the position they were betting on into a position that was bet against them. Like LTCM that would come after it, the traders at MGRM were relying on predictable patterns. When exogenous events surface, markets turn upside down, patterns change, and large bets are turned into large losses.

4 Lessons From LTCM & Metallgesellschaft

Lesson #1  Investment Versus Speculation
The first lesson is found where sound investment strategies turn into speculation. Had MGRM matched its long-term commitments with long-term hedges, it would not have gotten into trouble. By offering its dealers long-term contracts on oil at a fixed price for ten years, MGRM’s traders became speculators. To make a commitment as long as ten years for a commodity like oil, without covering, was an unsound business practice. As dynamic as the commodity markets are, they are prone to exogenous events like weather and geopolitical events. To assume that oil prices would remain in permanent backwardation seems incredulous today. Another lesson on investing versus speculation deals with the size of positions. Both MGRM and LTCM backed themselves into a corner by taking oversized positions within a market. In essence, they became the market. The size of their positions made them illiquid and vulnerable.

Lesson #2  Leverage Can Be Lethal
The two-sided nature of leverage is an old lesson. It can magnify returns on the upside, but on the downside, it can be lethal. The size of most derivative contracts allows investors or commercials to leverage their position by commanding a much larger position. That in itself is a form of leverage. When you add debt into the equation, the position of leverage is further magnified. In the case of LTCM, it was leveraged close to 100:1 towards the end. A position this leveraged allows no room for mistakes. Just as that leverage turned a 1% gain into a 59% return, it also magnified losses on the downside. In its final days, Long Term Capital would lose half a billion dollars – a loss of 20% of its equity base – in a single day. When you aren’t in debt, you can’t be forced to sell. You can afford to hold your position long-term. The partners’ view that all markets eventually revert to the mean was meaningless when large amounts of leverage were involved. Leverage makes you vulnerable.  It can force you to sell when you don’t want to. It removes the element of time out of the equation. LTCM’s mistake was defining risk as a function of volatility. Not enough consideration was given to leverage. Leverage by its very nature implies risk. To ignore the role leverage plays within the derivative market is perilous.

Lesson #3  Corporate Governance & Accountability
The role of corporate governance, both within organizations and outside them through governmental bodies, establishes the ground rules. In the case of LTCM, there wasn’t any governance. There were no independent risk managers watching over the traders. The partners monitored themselves and were accountable to no one. The same lack of supervision was also apparent in the case of MGRM. In most of the derivative mishaps like MGRM, LTCM, Orange County, Bankers Trust, Sumitomo Bank, and Barings Bank an institution healthy one day would appear insolvent the next day. There have been too many instances were a corporate parent would suddenly discover one of its traders or an affiliate had amassed enormous losses. A lone rogue trader or small band of traders had put the firms’ capital at risk in all of these cases.

Derivatives are complex instruments. They need constant monitoring. The fact that most of them are over the counter (OTC) makes them less liquid and more prone to credit risk. The fact that regulators allow this market to continue to expand without some form of supervision or prevention means we will have more LTCMs. The occurrence of losses is what discourages imprudent risk taking. Essentially, the actions of regulators have done just the opposite. They have indirectly encouraged more risk taking. By bailing out one firm after another, they have introduced a moral hazard in the marketplace. By its intervention, the Fed shielded well-heeled speculators from their mistakes. This only serves to encourage more risk-taking. A case in point: after the LTCM bailout, Meriwether was back in business fifteen months later.

Under Greenspan, the Fed has joined forces with the big banks in fighting against proposals for tougher disclosure. Instead of acting as sheriff, the Fed has worked to encourage and enlarge the market. Banks have been allowed to run up their exposure without regard to their long-term consequences, knowing “Big Brother” waits in the shadows to bail them out. While government supervision and disclosure requirements have served the securities market well, it is sadly absent in derivatives market. The current disclosure and monitoring rules in the securities industry were brought about by the lessons learned from the stock market crash of 1929. Perhaps it will take another tragic event to awaken regulators from their slumber. The current misguided view is that intervention rather than prevention can solve any crisis. Maybe the Fed also believes that markets will always revert to the mean.

Lesson #4   Rogue Waves Exist
The final lesson is the occurrence of rogue waves. These exogenous events happen more frequently than mathematicians would like. In the world of derivatives, they lie at the tail end of the curve. These remote and improbable occurrences wreck havoc on the models of certainty. If there is one lesson to be learned in investment markets, it is that change is a constant. Patterns emerge, become dominant, and then are abruptly replaced by other patterns. Each pattern is independent of the other.

Rogue waves are events that nobody foresees. An archduke is shot. Bombs are dropped at Pearl Harbor. North Korean troops cross the 38^th parallel. Saddam’s tanks roll into Kuwait. In the twinkling of an eye, the world changes suddenly. A crisis is born and markets are disrupted. Only in the computer-lighted rooms on Wall Street are such events considered to be a statistical aberration. They are non-events or acts of God outside the scope of reality. It is funny how often God has a way of showing up. There usually comes a day when, without warning, that rogue wave appears. On that day, random events turn into chaotic disorder. Investment patterns go off the charts. Money is made and money is lost. The difference in successfully riding the wave is one of anticipation.

The real danger in the derivatives market is that the models used to drive it are based on mathematical certainty when in fact the markets are inherently uncertain. How does one anticipate a country suddenly defaulting on its bonds, a remerging OPEC, the mind of a dictator, a madman, or a terrorist? You can’t. Markets will continue to remain uncertain. The fallacy lies in thinking they are certain. Models fail because they are based on the past. They continue to work until events change them. They fail at moments when they are needed most – when a rogue wave appears. In cash markets, rogue waves aren’t a problem. When there is no leverage, you can ride them out. You have the luxury of time to revert you back to the mean. When leverage is introduced or when positions are outsized in markets, rogue waves present problems. At its own peril, these are the lessons that Wall Street continues to ignore.

III. SYSTEMIC RISK AND CONTAGION

To trigger The Perfect Financial Storm, all that is needed is another shock to the financial system. It could be another LTCM or a monetary crisis like the European Monetary System in 1992. Today’s derivative contracts link the world of equities, debt, interest rates, and currencies as never before. The market is dominated by a handful of players whose inter-dealer positions increase linkage between economies and financial markets that cross over multiple borders. The risk to the financial markets is a crisis in one market spilling over into another. The danger inherent in the interconnectedness of global markets is that a small, uncontrolled event can turn into a major accident that magnifies as it ripples throughout financial system.

Because derivatives multiply leverage, they increase the debt-based buying power of hedge funds and speculators. Because of this leverage, a single trader, or group of traders have the potential to bankrupt an institution. Recent examples proliferate in the case of Barings, Orange County, and LTCM. Today high-powered derivatives have become so complex that their danger is not fully understood. Even sophisticated users of these instruments have succumbed to their complexity. Hedge fund managers like David Askin, LTCM's traders, and companies like Gibson Greetings, Procter & Gamble and Metallgesellschaft have all fallen prey.

The Derivative Chain Reaction

What makes derivatives so prone to financial crisis is that not only do they amplify leverage, but they are also heavily dependent on a highly liquid money and capital market. Users of these instruments rely on broker/dealers in their role as market makers to keep these markets liquid. Those same dealers rely on the repurchase markets to finance their security positions. These dealers are in turn dependent on money-center banks for lines of credit that they can use when they experience difficulties in rolling over positions or meeting obligations. In addition organized futures and option markets make extensive use of credit lines for instantaneous delivery of cash to satisfy margin calls. All the players in this game are highly leveraged. In the case of securities dealers, they tend towards leverage and concentration. The same is becoming true of the large money-center banks. It is a tightly connected system where leverage makes all of the players vulnerable. Failure of one element in the chain can bring the whole system down. The whole system is dependent on the active support of central banks in the area of liquidity management.

This was the lesson of LTCM. Because of its loans from broker/dealers and money center banks and the position of its counterparties, LTCM’s failure had to be contained. LTCM’s demise could have put each one of its counterparties into a naked hedge position, holding on to only one side of the contract because the other side had disappeared. If each one of its counterparties sold out, they would have overwhelmed the system. Essentially, LTCM’s failure would have been similar to a bank run in the 1930’s.

Risk – The Essential Element in Derivatives
For regulators and investors the opaqueness of this highly complex market has made it more difficult to ferret out potential problems. Unlike the period prior to the breakdown of the Bretton Woods system, when currency and interest rate risk were nominal, risk was centered on the balance sheet. As a result of the breakdown of fixed exchange rates under Bretton Woods, participants had to deal with increased exchange rate and interest rate volatility. There was also an effort to circumvent discriminatory regulations and tax laws. The result was the growth of the derivatives market, which began to flourish after the introduction of the Black-Scholes model. The growth of derivatives made it possible to turn risk into a commodity that could be bought, sold, and restructured from the underlying asset.

Innovations in Risk Taking

The whole process that unfolded after the breakdown of fixed exchange rates led to disintermediation of the financial system from a floating rate system of currencies, the end of fixed commissions on Wall Street, the introduction of Government Sponsored Entities (GSE) in the credit markets to the growth of money markets. Both sides of the bank balance sheet were disintermediated. Commercial paper replaced bank loans. Certificates of deposit replaced deposit liabilities at banks. This evolution gave way to the birth of money markets, which became a further engine of credit. The mutual fund industry broadened and deepened participation in the financial markets and modern portfolio theory changed buy and hold investing into an active, trade-driven approach to portfolio management.

All of these innovations increased the need to manage risk. For institutions, corporations and investors, derivatives became the answer. Money center banks and Wall Street firms moved in to facilitate the move towards risk-based management. For banks the loss of relationship finance and corporate loans motivated banks to seek another source of revenue. Competition from the financial markets had depressed lending margins, so banks seized upon OTC derivative activity as a substitute for less profitable lending. Providing liquidity to the broker/dealer market, becoming a major underwriter of OTC derivatives, and trading for their own account soon became a major source of bank profits. The result is that the OTC derivatives market has grown from $3.5 trillion in 1990 to close to $100 trillion today. The growing need for custom-tailored products that met the specific needs of a user caused the OTC market to explode in size versus the growth of exchange-listed derivatives. This market is less liquid and prone to greater credit risk for the users.

The OTC market has created several problems that are generally avoided on supervised exchanges. There is a lack of transparency, liquidity, and competitive pricing. It has no centralized location. There are no rules and boundaries. OTC derivatives aren’t openly traded, therefore price information is less transparent. Market information is lacking since only a few large institutions control it. Large money center banks dominate this market – concentrating power in the hands of a few key players. The large banks that dominate the market are also lenders to the end-users of derivatives. This makes the banks doubly exposed as writers and lenders to the same market. Because of this interconnectiveness, if one of these institutions failed, it would create a systemic risk that could bring the whole system down. The banks were both writers of derivatives and lenders to LTCM. In addition they were mimicking many of LTCM moves, which turned them into their own breed of hedge fund.

Another danger of this market is the off-balance sheet nature of OTC derivatives. This makes traditional regulatory and analytical analysis less effective. Traditional bank regulators have focused on bank balance sheets as a tool to assess whether banks have adequate capital to cushion them from potential losses. Capital requirements are based on ratios of equity to total assets. Because OTC derivatives are off-balance sheet in nature, they have made traditional capital requirements ineffective. This raises a serious issue when comparisons are made between the balance sheet assets of banks to their off-balance sheet derivative holdings. The notional value of derivative contracts are in many cases 40-50 times the value of balance sheet assets. This could create a future problem due to the exposure of contracts to a change in the underlying assets, which would necessitate a mark-to-market value of the derivative contract.

The Destabilizing Attributes of Derivatives

The plethora of crises throughout the 90’s has provided ample evidence that the growth of derivatives has made financial crises more virulent and the widespread use of derivatives has increased the risk of financial storms. The sheer size of the market has increased their role in financial crises. They can accentuate booms on the upside and amplify busts on the downside. They can magnify the movement of prices and cause volatility to gyrate. The movement of price and volatility reinforce each other in times of difficulty in the financial markets. There are five attributes of this market that make any one of them the trip wire for financial disaster.

Dynamic Hedging
The use of dynamic hedging can be destabilizing in itself. This technique transfers risk from users to the market makers. When all market makers want to delta hedge in the same direction, at the same time, it becomes a one-way market with no takers on the other side. As a result, the markets break down and become illiquid.

Lack of Market Transparency
Because the OTC market for derivatives isn’t transparent, it is difficult to judge equilibrium prices due to lack of knowledge of supply and demand. This can contribute to instability during periods of financial stress. The fact that this market remains opaque makes it harder for participants to gauge the underlying structure of financial positions as the price of the cash markets change. The balance between buy and sell orders triggered by dynamic hedging can remain obscured so the market dynamics remain hidden.

Dependence on Liquidity
Because OTC contracts don’t trade on organized exchanges they are liquidity-dependent. During periods of market tension, where bid and ask spreads widen, market players may withdraw, thereby drying up liquidity. This lack of liquidity disrupts the risk management process so that actual hedging strategies result in involuntary risk exposure. This is what happened during the 1987 stock market crash. During periods of financial stress, margin and collateral calls increase forced selling and aggravate price declines. As prices decline, margin calls increase and trigger a need for credit. This can force interest rates to rise as money-center banks tap the interbank market. Unless central banks intervene, short-term costs would increase, further exacerbating liquidity.

Leverage Levels
Perhaps one of the most dangerous elements of the derivatives market is the amount of leverage they offer. This credit extension encourages speculation. The leverage offered by derivatives allows speculators to exaggerate prices on the upside in bull markets and on the downside in bear markets. Derivatives allow hedge funds and other speculators to take large positions, and in certain cases, mounting to trillions of dollars. LTCM had roughly $3.5 billion in equity, but controlled $1.25 trillion in notional value in derivative contracts. Because of the leverage and size of their bets, derivatives have the potential to destabilize markets.

Concentrated Control
The final risk is imposed by the concentration of a handful of global dealers in the risk management business.  The top seven banks control 96% of all derivative holdings by American banks. One bank in particular, J.P. Morgan Chase, accounts for close to 60% of outstanding bank derivative holdings. 7 Because these banks hold large inter-dealer positions, a problem with any one of the players could spill over into others. Each of the major players is so large and the positions so concentrated that any one of them could become another LTCM.

The Domino Effect
Because this market has become so large, so concentrated and interconnected, it has the potential to implode into a worldwide financial contagion. A small, uncontrolled event could develop into a major financial crisis. It could begin with any one of the major players caught on the wrong side of a bet. The situation is amplified by the leverage of derivatives. It spreads like brush fire because the participants are interlinked. This creates a domino effect as the contagion crosses over financial markets and economic borders rippling through the world financial system. Volatility is magnified in the heat of forced selling. Price declines trigger margin calls, which causes more selling. Bid and ask spreads open up, credit spreads widen, and liquidity dries up, credit costs go up. It happened in 1987, in Mexico in 1994, in Asia in 1997, Russia and the U.S. in 1998.

Could it happen again? Have the derivative markets become so large and so concentrated that another contagion much larger and involving even a bigger player could not be contained?

Yes.

In my estimation, the disintegration of the derivative market is likely as this market mushrooms in size and becomes more concentrated. When markets are dominated by a small handful of institutions, market liquidity becomes less resilient to shocks to the system. With large, interconnected players, contagion risks increase and the market’s ability to absorb price shocks is impaired. The derivative market is much larger today than it was in 1998 when LTCM got into difficulty. The players have become more concentrated. The models on which the markets trade still define risk in terms of volatility. Leverage is ignored. Liquidity is misunderstood. Regulators are asleep.

We must now gird ourselves for the next crises which may become even larger and uncontrollable. We know they currently exist in the world’s financial system. They are appearing in the U.S. credit and financial markets, in Argentina, in the emerging Euro, and in Asia. Because the markets have become so interlinked, a storm in one market can meet up with a storm front in another market. The stage is now set for the international jet stream or interbank market to bring these storm fronts together to form The Perfect Financial Storm.

Triggers and Chain Reactions

Like 1991's Perfect Storm, there now exists the possibility of a similar event in the financial markets. The financial radar screen shows three storm fronts gathering momentum: the stock market, the economy and the currency market. The international monetary system is the jet stream that could bring these storm fronts together. This huge inter-bank market that moves trillions of dollars of currencies around the globe on a daily basis could turn into a contagion that becomes unstoppable. The increased linkage between financial markets, in each economy and across borders, the large amount of inter-dealer positions in derivatives, the degree of leverage in the financial system, and the speed of technology to transmit market moving news events have created the possibility for all storm fronts to converge.

Systemic risk exists everywhere. It has been brought about by linkage and leverage. There now exists the possibility of a system failure that could precipitate a chain of events that spreads like brush fire. As we've seen in the past, turbulence in one market spills over into another as an unforeseen event triggers a chain reaction. Prices in markets implode, liquidity disappears, credit spreads widen, margin calls are made, forced selling accelerates, and the banking system breaks down and fails. The efficacy of central bank monetary policy is simply overwhelmed. The amount of leverage in the global financial system and the degree to which it is interconnected has become a force that becomes magnified as it ripples through the world's financial system.

The ability of governments and their central bankers to intervene and contain the crisis is limited. Today's system of derivative finance has moved beyond their control. This system is even more apparent as the OTC derivative market has moved beyond borders. It has become transnational falling under no one's jurisdiction. This has shifted the power between regulators and large financial institutions. In their efforts to provide liquidity to the financial system, central bankers have removed the liquidity risk out of derivative finance. In their role as lenders of last resort, they have encouraged the players such as broker/dealers and banks to take on even more risk through increasing leverage and thinly capitalized balance sheets. Their derivative book continues to