Derivatives Turbulence

Since late 2006, 384 financial services firms have 'imploded' in the USA, and a couple of hundred in other countries have closed. (see www.ml-implode.com)
Most were specialising in mortgages or over exposed to them. The listing of 'imploded' firms includes bankruptcy filing, temporary but open-ended halting of operations, or a "fire sale" of the firm. They include retail, wholesale, subsidiaries and entire companies.
With the massive downturn in the economy and slow recovery, banks needing to restructure their balance sheets are reluctant to lend, and are applying stricter credit conditions, probably until real growth and inflation both look persistent.
The high leverage of credit derivatives make them more fragile than ordinary fundsGoldman Sachs and Morgan Stanley each suffered at least 10 days of trading losses in the second quarter, underlining how turbulent markets have cast a pall on Wall Street since April, the FT reports.
On three occasions, Goldman’s traders posted shortfalls of at least $100m, while Morgan Stanley’s traders reported losses of between $50m and $75m twice, but never lost more than $75m on any one day. These daily losses are subsumed within monthly profits, so that the actual gross losses and profits are unknown. We can see some losses as reported by US commercial banks in the past.GS and MS are among banks responsible for unreported risk, among 5 banks that failed to report hundreds of $billions of dollars in credit derivatives bought from foreign counter-parties in 2009, leaving those exposures below the radar of regulators in the US and Europe. The under-reported exposures to credit default swaps came to light as the US Federal Reserve and the Bank for International Settlements were preparing first-quarter reports of the industry’s lending and risk activities. It was revealed as a footnote to the BIS report’s lengthy tables (June 2010). “This underscores how little transparency there was and how much information was missing,” said one BIS official familiar with the report. The missing data concerns financial institutions that were hastily granted bank holding company status in 2008 as safe harbour action in the middle of the Credit Crunch - essentially so that the investment banks now registered as deposit-taking could resort to the Federal Reserve's liquidity window for short term financing as wholesale market liquidity evaporated. The failure in reporting underlines how the conversion to Fed-regulated banks also introduced those firms suddenly to a raft of complex bank reporting standards, and raises new questions on the lack of scrutiny they faced under previous regulators (the SEC).
The Fed, following a review of its quarterly report on cross-border risks, discovered that the group, which included Goldman Sachs, Morgan Stanley, American Express and CIT, only submitted claims on credit derivatives up to the amount where there was a corresponding position to hedge against. The additional risks, which totalled $400bn in the first quarter, were left out.
When in its recent quarterly return we see that GS earned 35% of its profits from derivatives, it is more than clear that hedging is only part of the reason for derivatives exposure and places question marks over how banks have netted their derivatives exposures to minimise capital reserve requirements, quite apart from the 'deouble-default' risk in a systemic crisis, which is shown up by the case described below of AIG.
BIS has pushed for transparency in the derivatives market, particularly that for instruments such as CDSs that are traded over the counter. Robert Rubin and Alan Greenspan successfully stopped credit derivatives from being subject to exchange clearing in 2000, soon after they had supported repeal of Glass-Steagal - two decisions that should have returned long before now to haunt them.
In a speech, Stephen Cecchetti, head of the monetary and economic department of the BIS, noted the events that threatened the world’s financial system in 2008 stemmed largely from the lack of knowledge about each bank’s risks. The Fed concluded the failure to report the derivatives positions stemmed from a lack of familiarity with requirements rather than any intentional move to withhold  details. 
Regulators  plan now to update their 2009 cross-border risk reports to add the banks’ missing data.Lehman Brothers books are taking years to net, recover and pay off, involving subsidiaries of Lehmans in many jurisdictions. But, at least the counterparties cannot sue on underwriting claims. By contrast, AIG's trading partners may force the now state-owned insurer to pay up for insured losses on corporate loans and mortgages for years, even decades, to come, complicating U.S. efforts to stabilize the firm.
European banks including Societe Generale SA and BNP Paribas SA hold almost $200bn in guarantees sold by AIG allowing the lenders to reduce the regulatory capital reserves against write-downs and for loan-loss provisions. The firms may keep the contracts to hedge against declining assets rather than canceling them as AIG said it expects banks to do (according to David Havens, MD of Hexagon Securities LLC). He said, “For counterparties to voluntarily terminate those contracts makes no sense. There’s no question that asset values have soured on a global basis. With the faith and credit of the U.S. government backing those guarantees, why would they give that up?”
The falling value of holdings backed by the swaps may force AIG to post more collateral, stressing the insurer’s liquidity and credit ratings in ways that caused the firm’s collapse in Sept.'08, when AIG needed a U.S. bailout valued at $182.5bn after handing over collateral on a different book of swaps backing U.S. subprime mortgages.
As can be seen by the graphs derivatives contracts tend to be short term. The maturities for which AIG issued security guarantees appears absurd; how can the risks be quantified? God contracts for example shot up in the last couple of years in anticipation of fiscal uncertainties or anxieties. But this is trading on subjective or emotional or kneejerk opinion. The average weighted term of the European swaps protection of residential loans is more than 25 years, and for corporate loans about 6 years (AIG regulatory filing). Contracts covering corporate loans in the Netherlands extend almost 45 years, and the swaps on mortgages in Denmark, France and Germany mature in more than 30 years.
The portfolio shrank by half in 15 months to $192.6bn by March 31.
AIG’s models show banks will abandon more contracts. It expects the banks to cancel “the vast majority” of contracts in the next year as regulatory changes reduce the benefits of the derivatives for lenders.Last month, AIG said in a regulatory filing that it may be at risk for losses for “significantly longer than anticipated” if the banks don’t terminate their swaps. “Given the size of the credit exposure, a decline in the fair value of this portfolio could have a material adverse effect on AIG’s consolidated results”(AIG June filing).
The SEC asked for AIG to add the disclosure to the insurer’s “risk factors”.
RBS Group Plc, Banco Santander SA, Danske Bank A/S, Rabobank Group NV and Credit Agricole SA’s Calyon are also among banks that purchased the swaps. The banks could be forced to raise $10bn in capital if AIG fails (AIG June filing).
Santander said (to Bloomberg) through a spokesperson that the bank’s risk of an AIG failure is insignificant and fully collateralised. Calyon declined to comment (to Bloomberg). Representatives of the other lenders didn’t immediately return messages seeking comment.Counterparties terminated or allowed to expire $27.8bn in the so-called regulatory relief swaps in the first quarter, and AIG got notice for another $16.6bn terminated in April. Some of the remaining swaps have suffered losses for which AIG posted $1.2bn in collateral as of the first quarter. Bloomberg reported, “You’ll have an increasingly toxic pool of credit-default swaps every quarter” as the least risky swaps are terminated, said Donn Vickrey, analyst at research firm Gradient Analytics Inc. “Swaps that are being held are done so for two reasons, either for regulatory relief or because they’re ‘in the money’” which means they are valuable hedges against asset declines.
Some of the swaps are no longer being held for regulatory relief, and AIG has reclassified $3bn in swaps through March 31 likely to be kept after regulatory benefits expire, with $393m liability against those swaps.
Gerry Pasciucco, hired by AIG in November to clean up the Financial Products unit that sold the swaps, said in an interview in December that the European swaps would mature over time without loss and faced very little risk. Pasciucco said in April that future losses will be limited. The $192.6bn figure for the swaps includes $99.4bn tied to corporate loans and $90.2bn linked to prime residential mortgages.
The analysts' view is that the size of the portfolio and the ‘black box’ nature of its underlying loans and assets mean that mark-downs in the regulatory CDS portfolio may prompt collateral margin calls that pressure AIG’s liquidity.
The US government’s rescue includes a $60bn credit line, $52.5bn to buy mortgage-linked assets owned or insured by the company, and investment of $70bn. AIG plans to reduce its debt under the credit line by $25bn by handing over stakes in two non-U.S. life insurance units. AIG has tapped about $43bn from the line as of July 15 '10.

ITEM FOR WOMEN BANKERS - DEBRA'S CASE

The voluptine Debrahlee Lorenzana claims that her ex-employers in the Chrysler Building forbade her "to wear sexy garments or high heels because they distract" her male colleagues. “I can not help it that I’m curvacious,” she told reporters for NY Daily News, which just loved the story.
“And I am not about to go overeat to gain fifty to one hundred pounds simply because my employer wants me to be like everyone else.” The media have classed her as a babe that was too hot for Citigroup to handle.The story is no sillier than a lot that goes on in celebrity magazines. The 33-year-old "eye-candy from Queens" filed suit in Manhattan Supreme Court. She alleged she was directed to refrain from turtlenecks, pencil skirts and tailored suits because clingy garments attracted excessive attention on the job. The presumption seems to be that Citicorp managers considered productivity suffered, hurting someone's bottom line - the inverse of what 'sexiness' is more often assumed to deliver positively to productivity? If sexiness is economically damaging by being distracting, or only in banking, there is a lot to be questioned about office work or in a bank branch.
Her attorney, Jack Tuckner said, “Debrahlee Lorenzana might possibly be very appealing in anything she wears.” Tuckner works for Tuckner Sipser Weinstock & Sipser and clearly find Debra's deportment productive in his firm, as does whoever she now works for.Feminism continues to debate the physical objectification of sexiness figurined as female. Post-modern post-feminism has no problem with that, but that's like saying bankers have no problem making money from asset bubbles. Bankers (not just the men) anyway are not feminist or even post-feminist, not an issue in a money-culture. Banks have a well populated history of losing 'constructive dismissal' suits as their kneejerk response to internal complaints of gender-bias and sexism etc. Citigroup, was the employer of a Debra, a Latino terminated for being unwilling to dress down in mid-town New York. A tearful Debrahlee Lorenzana read a prepared statement explaining why she is a victim of sex discrimination and asking for a human rights investigation. She claims she was fired as a business banker at Citibank after complaining that male colleagues called her good looks distracting. What males complain about that?
She says something that is certainly not post-modern or post-feminist, that being beautiful is a curse for her and always has been, because people attribute her achievements to her looks, so she's had to work twice as hard to get ahead, which is not an argument that I can follow. She says she can't win though hopes to by suing Citibank for firing her for being too sexy. Citibank certainly is accused of questionable actions — male managers pulling her aside and giving her a list of prohibited clothes and firing her for being late on dates that checked out to be weekends. She is not helping the case by her idea that she's just too beautiful - although I can think of some ugly male bankers who got to the top like Dick Fuld, generally prettiness gets there too - but other than in sales and PR it is not a major factor surely?
In letter she wrote to Citibank's HR department she said, "Other female employees were able to wear such clothing because they were short, overweight, and they didn't draw much attention, but since I was five-foot-six, 125 pounds, with a figure, it wasn't 'appropriate'. . . . Are you saying that just because I look this way genetically, that this should be a curse for me." Apparently she's five-foot-eight according so some press coverage, but otherwise she could be telling the exact truth here, except the genetically bit has been augmented as proven by a video found by the voracious press in which when a single-Mom insurance agent she went to get a DD to become two boobs on a stick in her words, like Pamela Anderson and to find her own Ben Affleck, an how plastic surgery is the "best thing ever" and commonplace nonsense like that? At JP Morgan Chase the rumour is that she'll be sacked there too this time for talking too much to the press! Her lawyer says if JPM&C sack her they'll sue that bank also. Her new boss has tried to get Debra to cancel television interviews.In the complaint against Citigroup, Debra claims that she was not properly trained and that she was "a target" to her colleagues. That is interesting - lack of formal training. She says she was a victim of sex discrimination and then retaliation for speaking up.I wonder what she can possibly imagine getting compensation, not even distress since she appears to relish the publicity and does not appear to have suffered significant loss of earnings, except of course legal fees. The fed-up femme fatale made a formal complaint to Citigroup's HR in May last year, and asked for a transfer, which she got in July. But at the new branch she was chided for failing to recruit new customers and was dismissed in August last year.
When the case came to court her gender-discrimination suit was dismissed because her contract with Citibank called for any disputes to be settled in private arbitration.
Ms Lorenzana, who wore a sleeveless black dress, during the televised interview, repeated her claims that Citibank allegedly canned her for wearing sexy outfits at work.

READ MY LIPS

USA HOUSEHOLD WEALTH AND DEBT

In 2000, USA household wealth was $44 trillion and rose to $65 trillions in 2007 or equal to 108% of world GDP or twice the value of world trade or 4 times the world's energy consumption by $ value. It fell by $18 trillions and has recovered $5 trillions, though debt has fallen little. Household debt was 20% of USA household wealth in total and then rose to 28% before improving to 24%. But that's only the average. A fifth of the population or of households are too poor to have bank debts. Half the population had net wealth and now don't. Som will be dwelling on a 'lost decade' if they only think in money terms? They're the so-called middle class that both parties remain desperate to help and woo for votes. The Democrats also want to do something for the poor at least in health care insurance reform.
The USA has about one third of world wealth and a similar proportion of world output. Roughly 10% of the population own 70% of US wealth, top 1% own 40%. The bottom 40% owned less than 1% of the nation's wealth, half of whom own nothing valuable!
When it comes to debt that is not distributed in the same proportions as wealth, but will be concentrated in the middle of the US household population. Do not assume that income tax is exactly proportionate to wealth distribution either. The top richest 1% pay 33% of federal income tax; the next 9% pay another third; the next 15% pay 22% of the income taxes; and the next 25% pay 33% of income tax. The next 10% pay 3% and the last 40% pay no income tax, but a lot of sales tax and local taxes for which they get something in return, maybe most of it somehow, let's hope so. The US has a progressive tax structure which taxes less for smaller incomes. But the US does not directly tax wealth except the estate tax (what in UK is called death duties and inheritance tax).
A quarter of households retain net wealth and are rich of which the top fifth (5% of all households) had under 10% loss. The top 1% may feel that in real terms or at least relative to everyone else they are in serious profit gains from buying distressed assets at discounts that will do well for them and their heirs in the future?

COUNTRIES OF THE WORLD BY GOVERNMENT BORROWING RATIOS TO GDP

BANKS OF THE WORLD BY CUSTOMER LENDING

CONTRACTS FOR DIFFERENCE? SOLD SHORT?

CBOT Floor - Credit default Swaps (CDS) and Contracts for Differences (CFDs), similer to put options, are major tools of 'short-selling' generally (which depends on stock lending), are employed on a large-scale by hedge funds, but also by medium to small brokers, and by individuals speculators, and were at the heart of the relentless fall in bank shares especially in the two years after June 2007 when the bottom fell out of the markets followed by the credit bottoms falling out their trousered-economies.
CFDs are a leveraged way of participating in short-selling to profit from loss of market price in stocks, and as importantly, a way to profit from how short-sellers can cause stocks to fall in price! Many small sell-orders can drag a price down far more effectively than one much bigger sell-order. The blame for the credit crunch (that triggered an Anglo-Saxon recession by pricking the asset bubbles of credit-boom economies) is a long list that includes:
Sub-prime, self-certified, and buy-to-let mortgages sold to over-indebted borrowers;
Bugs in models of credit ratings agency that caused the models to be indifferent to defaults data and rate many Asset Backed Securities (ABS) far too highly;
Asset price weakness of Collateralized Debt Obligations (CDOs, also called ABS) when the bonds were offered into secondary markets that proved to be illiquid;
Credit Default Swaps (CDS) insurance-style derivatives on CDOs, and their further derivatives calls CDS Squared (CDSS);
Banks' inadequate levels of capital reserves, and their large 'funding gaps', which are banks' borrowings needed to fill the gaps between customer deposits and loans;
General accusations of weak regulation in an era of too-cheap money (low central bank discount rates);
Credit-boom economic growth policies in USA, UK and some other OECD countries such as Spain, Ireland, Greece, that also caused extreme imbalances in world trade;
Investor exuberance and blinkered risk-taking as property prices outpaced every other route to getting richer;
Extreme bias in bank lending in credit boom economies towards mortgages, property and consumer credit.
I could add other factors. But, surprisingly short selling, stock lending and CFDs have been treated as a tertiary symptom rather than also a major problem? A temporary ban was implemented on 'naked' short selling. This had limited effect because the rules totally misunderstood how short selling works to drag down stock prices. Note that short-selling and the equivalent of CFDs have been available for a century as a speculative way to profit iCFD short-selling, for example, was the lubricant for the German currency crash and hyper-inflation of 1923, and continued to be used in subsequent currency crises round the world - and in some minds especially in 1993 attack on sterling forcing it out of the EMS, called Black Wednesday. Shorting interest rates is well established.We see this again today in a sequence of sovereign debt crises and currency attacks. Traders are using every bit of political-economic news to perturb the markets, and sovereign debt is the current game of choice - why, because it can appear to the simple-minded to cover everything else in a national currency economy, which of course it does not really do so. Market regulators excuse call & put options, CFDs, in money market, bond and equities short selling as mostly legitimate risk hedging and also brokers need to maintain market liquidity by borrowing stock to sell when they are short of the stock, and so on. Hedge Funds and others have made $ billions of gains from asset price losses of longer term investors - one argument is that at least much of the value lost has been encashed and lost absolutely? The question is whether this is a source of sever systematic instability that should be checked. In defence of this lucrative activity, described by some as 'shooting turkeys in a barrel', various studies have been commissioned and published to show that profiting on the downside of markets is good, balancing, has little negative impact on prices, and is simply necessary! But, in crises when markets are volatile or obviously sliding, and when markets are nervous, easily moved by rumours and titbits of negative news, and when short term profit-takers out-weigh long term investors, then it becomes absurd to defend short selling or to assume that it is price-neutral or market-neutral!
At last there is some more determined action. A growing European consensus on the need for tougher regulation of CDS trading was reflected by Lord Turner, chairman of the UK FSA, who warned that naked trading in corporate CDSs could force companies into default. FSA has also said it is investigating stock lending - especially to identify where stock-owners have not been advised that there stock may be loaned out - to garner a fee for custodians - when the liklihood is that the stock will be returned worth less, like letting a hotel room to a rock band and getting it back trashed. A first-order problem is getting data on what's been going on for years and what is happening now?
Regulators in the US, Hong Kong and EU have outlined new reporting measures on short selling of equities while at same time trying to preserving liquidity benefits generated at the margin by short selling i.e. they seek to constrain the short term speculation. Europe and HK want more timely disclosure of short selling activity, America’s SEC is backing a rule that is resisted by traders who say it will detract from liquidity. The new rule seeks to block short selling if a stock falls at least 10% in one day. How that can practically operate is unclear. A Franco-German initiative, backed by Luxembourg and Greece, calls for regulators to be given “unlimited access” to a register of derivatives trading in order to identify who is trading and what they are doing. It proposes that derivatives transactions should only be allowed on exchanges, electronic platforms and through centralised clearing houses. Credit Default Swaps (CDSs) and CFDs are commonly used by banks and hedge funds to reduce their risk, but they are also popular with investors who buy and sell them with an eye to quick profit. Naked CDS and CFDs drove down Greek bonds this year and banks and financial companies last year, and the year before.
Lord Turner, who is also a member of the Financial Stability Board, which works on G20 global regulatory proposals. He wants regulators to look at the question of naked CDSs on both corporate and sovereign debt. “We need to think about whether we are being radical enough on credit default swaps . . . as to whether naked CDSs should be allowedd.” He is concerned that corporate CDSs can be easily manipulated to force a company into default, a form of market abuse. As before, however, hasty action is not advised! “We need to look at these issues very carefully. There is a danger of an oversimplistic belief that everything going on is shorting in the CDS market.”
Mario Draghi, chairman of the FSB, signalled this week that the group is focused on the issue. “This way of betting has systemic implications.The sense I have is that governments are increasingly uneasy with this. Whenever something has systemic implications, you can bet it is going to get systemic regulation.”