Post by jeffolie on Aug 12, 2007 15:03:39 GMT -6
The Undrinkable Well of Liquidity
When Warren Buffet, billionaire investor and chairman of Berkshire Hathaway, first characterized derivatives -- especially the lightly-regulated, over-the-counter variety -- as "financial weapons of mass destruction," it caused a ruckus on Wall Street.
Industry insiders and regulators rushed to the defense of these synthetically-created securities. They touted the efficiencies and other benefits of instruments that enabled all sorts of risks to be sliced, diced, and shuffled around in myriad ways, and they downplayed any potential shortcomings.
One key argument: these paper promises, whose value typically depends on something else (a stock option is one example), were being created, bought, and sold by sophisticated individuals and institutions who knew exactly what they were doing and who had little reason to engage in reckless or otherwise destructive behavior.
Recent events suggest that not only were significant downside risks wrongly dismissed, but that no small number of those who have been wheeling-and-dealing in these often breathtakingly complex instruments had strong incentives (e.g., fat commissions) to shove the most dangerous varieties into the portfolios of anyone and everyone, regardless of whether it was appropriate or not.
Unfortunately, now that the financial system has been polluted with all sorts of toxic financial waste, desperate and cash-thirsty financiers are discovering that the well of liquidity is undrinkable or running dry.
In "Market's Flaws Surface," Wall Street Journal reporters Alistair MacDonald, Ian McDonald, Henny Sender, and Carrick Mollenkamp detail some issues that have recently come to the fore and why "complex hedging tactics can't trump fear."
The past week's turmoil in stock and bond markets brought to light a mounting array of stresses in the global financial system as it struggles to adjust to disruptions once thought isolated to the subprime-mortgage market.
The biggest immediate issue -- a jump in short-term interest rates as banks became unwilling to make cash readily available to borrowers -- was met Friday by the Federal Reserve and the European Central Bank flooding markets with billions of dollars. The moves were joined by central banks in Japan, Australia and elsewhere.
Other stresses are popping up, too, many of them related to trades that involve derivatives -- complex financial instruments whose value can be hard to determine -- and to the activities of hedge funds.
At Citigroup Inc.'s credit-derivatives trading desk in London, volume has been so huge in credit-default swaps -- in which traders make bets on the likelihood of companies defaulting on bonds or loans -- that Citi can't keep up with orders. In the U.S., stock prices have been behaving bizarrely, with the shares of companies with seemingly poor prospects rallying. At the same time, U.S. securities regulators are probing the balance sheets of some U.S. investment banks to check whether they have been accurately recording the values of some derivative holdings.
The central banks' actions were aimed at bringing order to the frazzled markets. They helped calm the U.S., but not Europe, where fears persist that banks are overexposed to U.S. subprime-mortgage debt. The Dow Jones Industrial Average fell 31.14 to 13239.54, while trading in a range of about 225 points during the session. Yields on U.S. Treasury bonds fell, as investors turned to government bonds for safety. The pan-European Dow Jones Stoxx 600 index dropped 3.1% to 362.7.
Much of the recent turmoil is the result of fear. As investors have shunned risk, trading in some markets has dried up. But also behind the assortment of market glitches and unusual trading are massive changes in the global financial system that have taken place in the past decade.
Investment in hedge funds has boomed. Because they invest across a wide range of asset classes and regions, and take on debt to make their investments, these funds can transmit problems broadly. Hard-to-value derivatives also have boomed, but haven't been severely tested as now. Investors are learning that activities often taken for granted in established arenas such as the stock market -- knowing the price of an investment, for example -- can go bonkers in the world of derivatives.
Commercial-paper markets became caught up in some of these trends during the past week. Commercial paper, a staple investment for money-market mutual funds, are short-term loans typically issued by highly rated companies for less than a year. The market -- $2 trillion in the U.S. and nearly $1 trillion in Europe -- is considered one of the most easily traded and safest corners of the financial markets outside of U.S. government bonds.
But interest rates on commercial paper have risen as far and as fast as they did after the shock of the Sept. 11, 2001, terror attacks.
Behind the surge: Banks that typically lend to each other in this market were withholding loans to preserve money in case they needed to back up affiliates. Some European banks were facing credit squeezes because their affiliates might be exposed to U.S. subprime mortgages, bankers and traders say.
The commercial-paper problems hit Europe particularly hard. Investors worried that some European banks were exposed to U.S. subprime mortgages, particularly after German bank IKB Deutsche Industriebank AG disclosed on July 30 that its profits would be hurt by subprime exposure.
"It shows that there are so many interconnections today between different parts of the market that otherwise seem so disparate," says Eric Jacobson, director of fixed-income strategies at Chicago research firm Morningstar Inc.
The credit-default swap market also is a source of some concern. Investors increasingly turn to this market to make bets on the fortunes of companies, and to hedge themselves against the risk of a default. In the past few weeks, volume in indexes that track these derivatives has more than tripled, according to data from Deutsche Bank. By contrast, the so-called cash market, where the loans and bonds of individual companies exchange hands, has become almost totally frozen.
After trading a credit-default swap -- which banks exchange with investors, hedge funds and other financial institutions -- banks need to input the trade details into their internal computer systems and confirm the terms between parties. In 2005, regulators demanded that banks clean up huge backlogs in documenting these trades in this booming market, and they have made solid progress toward doing so.
The Federal Reserve Bank of New York demanded that banks clean up these backlogs in part because it worried dealers could lose track of who owes what to whom. Officials also worried that a backlog of unconfirmed trades could be called into question in times of market stress.
But Citi's London credit-derivatives office hasn't been inputting terms fast enough to keep up with high trading volumes in at least one of its markets, according to people familiar with the matter. As a result, a backlog of unprocessed trades has built again, they said.
"Based on industry metrics, our credit derivatives trade-confirmation and settlement activity is very much in line with the rest of the industry. We have heard no complaints from our clients," a Citigroup spokesman said.
As demand for credit derivatives increases, the market has become subject to other strains. In the face of huge price swings and a growing aversion to risk, it has become more difficult to execute trades. That is what traders refer to as liquidity risk; it may mean both dealers and hedge funds that thought they could get out of positions or hedge those same positions may be left with large exposures.
Indexes that track this market have swung widely in recent weeks. The volume of trades some dealers are willing to buy and sell have shrunk drastically, both dealers and their hedge-fund clients say. Both sides add that there is also a huge gap between the prices buyers say they will pay and the prices sellers say they will take. That further discourages orders.
Meanwhile, the Securities and Exchange Commission is worried about how the market is handling another kind of derivative called collateralized-debt obligations.
Securities regulators are checking the books at top Wall Street brokerage firms and banks to make sure they aren't hiding losses in the subprime-mortgage meltdown, said people familiar with the inquiry. The SEC is looking into whether Wall Street brokers are using consistent methods to calculate the value of subprime-mortgage assets in their own inventories, as well as assets held for customers such as hedge funds, these same people said. The concern is that the firms may not be marking down their inventory as aggressively enough.
The broader problem for the market is that trading in many of these instruments is so sparse, it has become increasingly difficult for investors and investment banks to put an accurate value on them.
Writing in the Financial Times, author and law school professor Frank Partnoy describes an even more fundamental problem with synthetic securities in "The Derivatives Vacuum."
The recent collapse of two hedge funds at Bear Stearns Asset Management raises two questions few people can answer. How did they lose so much money so quickly? And where else are similar problems buried? The unsatisfying answers illustrate why markets suddenly have become so volatile.
First, it has been widely reported that the Bear Stearns hedge funds lost money on highly rated derivative securities based on subprime mortgages. Essentially, these securities, known as collateralised debt obligations (CDOs), were complex bets on how many people would repay the money they borrowed to buy homes. Although Bear Stearns has not yet admitted which versions of these derivatives it held, one can glean some characteristics from letters the funds sent to investors months ago.
On May 15, the newer of the two funds reported it was down 6.5 per cent for the year. By contrast, the value of many subprime-linked securities had been sliced in half as early as February. In other words, the fund was not simply tracking the subprime markets: it was doing better, presumably because it was buying highly rated securities. Still, many investors in both funds were nervous about the losses and asked to redeem their investments. The funds said No.
On June 7, losses climbed to 19 per cent. Investors asked how the newer fund lost so much money, when the subprime markets were rebounding and many commentators, including Ben Bernanke, the Federal Reserve chairman, suggested a crisis had been avoided. Indeed, as the markets bubbled with optimism at the time, Everquest Financial, a new firm that had purchased most of its $700m of assets from the two Bear Stearns funds, filed for an initial public offering. This timing was baffling: why did the two funds fall while the markets rose?
Then came the whopper: on July 18, Bear Stearns admitted it could not figure out how much money it had lost. It said: “A team at BSAM [Bear Stearns Asset Management] has been working diligently to calculate the 2007 month-end performance for both May and June for the funds.” The funds refused to answer investors’ questions. Less than two weeks later, they filed for bankruptcy protection.
Bankers Trust, the most sophisticated derivatives firm of the 1990s, made similar mistakes. In 2001, the chief executive of American Express shocked investors when he admitted the company “did not comprehend the risk” when it lost $826m on CDOs. Freddie Mac and Fannie Mae have taken years to value derivatives losses, as did Enron.
As in those cases, the Bear Stearns funds did not lose money in the manner most people think. If the funds lost most of their money in May and June, they must have held positions other than highly rated CDOs. Some experts say the funds also made lower-rated subprime bets that were designed to hedge risk by moving in the opposite direction. Unfortunately, they did not. The Bear Stearns funds held opposing positions that unexpectedly moved in the same direction. As many traders say, the only perfect hedge is in a Japanese garden.
Anyone looking for clues to buried subprime losses elsewhere also should understand that many institutions do not “mark to market” complex derivatives to reflect changes in value over time. Many pension funds and insurance companies hold subprime-linked derivatives, but have not yet recorded losses. Others have recorded some, but not all, losses. Indeed, it is possible the Bear Stearns funds lost money during February, but did not record those losses until months later.
Some institutions argue that accounting rules permit them to hold derivatives at cost. Others say they need not reflect a loss until there is compelling evidence of a decline in value, such as a downgrade of the investments’ credit rating. As a result, it is virtually impossible for investors to understand how much exposure an institution really has to the subprime markets.
The common denominator of derivatives fiascos such as that of the Bear Stearns funds is that the answer to the above questions is: “No one knows.” Subprime exposure can remain buried and unexplained for months.
Now that investors seem to understand this, the markets are swinging wildly. Volatility is highest when people realise they cannot figure out what investments are worth.
Former Federal Reserve Chairman Alan Greenspan once said that "the clearest evidence of the perceived benefits that derivatives have provided is their continued spectacular growth." Based on the carnage that a huge build-up of unsaleable derivatives has helped to create in global financial markets, it seems that's one more thing "the maestro" has gotten wrong.
www.financialarmageddon.com/
I have listed some of the highlights:
-As investors have shunned risk, trading in some markets has dried up.
-The biggest immediate issue: a jump in short-term interest rates as banks became unwilling to make cash readily available to borrowers was met Friday by the Central Banks
-knowing the price of an investment, for example -- can go bonkers in the world of derivatives
-regulators are probing the balance sheets of some U.S. investment banks to check whether they have been accurately recording the values of some derivative holdings
-it has become more difficult to execute trades
-Commercial-paper markets became caught up in some of these trends during the past week
-In the past few weeks, volume in indexes that track these derivatives has more than tripled, according to data from Deutsche Bank. By contrast, the so-called cash market, where the loans and bonds of individual companies exchange hands, has become almost totally frozen.
-This is not the first time smart people have bought complex derivatives and later said they could not calculate their losses.
-it is virtually impossible for investors to understand how much exposure an institution really has to the subprime markets
-Subprime exposure can remain buried and unexplained for months
When Warren Buffet, billionaire investor and chairman of Berkshire Hathaway, first characterized derivatives -- especially the lightly-regulated, over-the-counter variety -- as "financial weapons of mass destruction," it caused a ruckus on Wall Street.
Industry insiders and regulators rushed to the defense of these synthetically-created securities. They touted the efficiencies and other benefits of instruments that enabled all sorts of risks to be sliced, diced, and shuffled around in myriad ways, and they downplayed any potential shortcomings.
One key argument: these paper promises, whose value typically depends on something else (a stock option is one example), were being created, bought, and sold by sophisticated individuals and institutions who knew exactly what they were doing and who had little reason to engage in reckless or otherwise destructive behavior.
Recent events suggest that not only were significant downside risks wrongly dismissed, but that no small number of those who have been wheeling-and-dealing in these often breathtakingly complex instruments had strong incentives (e.g., fat commissions) to shove the most dangerous varieties into the portfolios of anyone and everyone, regardless of whether it was appropriate or not.
Unfortunately, now that the financial system has been polluted with all sorts of toxic financial waste, desperate and cash-thirsty financiers are discovering that the well of liquidity is undrinkable or running dry.
In "Market's Flaws Surface," Wall Street Journal reporters Alistair MacDonald, Ian McDonald, Henny Sender, and Carrick Mollenkamp detail some issues that have recently come to the fore and why "complex hedging tactics can't trump fear."
The past week's turmoil in stock and bond markets brought to light a mounting array of stresses in the global financial system as it struggles to adjust to disruptions once thought isolated to the subprime-mortgage market.
The biggest immediate issue -- a jump in short-term interest rates as banks became unwilling to make cash readily available to borrowers -- was met Friday by the Federal Reserve and the European Central Bank flooding markets with billions of dollars. The moves were joined by central banks in Japan, Australia and elsewhere.
Other stresses are popping up, too, many of them related to trades that involve derivatives -- complex financial instruments whose value can be hard to determine -- and to the activities of hedge funds.
At Citigroup Inc.'s credit-derivatives trading desk in London, volume has been so huge in credit-default swaps -- in which traders make bets on the likelihood of companies defaulting on bonds or loans -- that Citi can't keep up with orders. In the U.S., stock prices have been behaving bizarrely, with the shares of companies with seemingly poor prospects rallying. At the same time, U.S. securities regulators are probing the balance sheets of some U.S. investment banks to check whether they have been accurately recording the values of some derivative holdings.
The central banks' actions were aimed at bringing order to the frazzled markets. They helped calm the U.S., but not Europe, where fears persist that banks are overexposed to U.S. subprime-mortgage debt. The Dow Jones Industrial Average fell 31.14 to 13239.54, while trading in a range of about 225 points during the session. Yields on U.S. Treasury bonds fell, as investors turned to government bonds for safety. The pan-European Dow Jones Stoxx 600 index dropped 3.1% to 362.7.
Much of the recent turmoil is the result of fear. As investors have shunned risk, trading in some markets has dried up. But also behind the assortment of market glitches and unusual trading are massive changes in the global financial system that have taken place in the past decade.
Investment in hedge funds has boomed. Because they invest across a wide range of asset classes and regions, and take on debt to make their investments, these funds can transmit problems broadly. Hard-to-value derivatives also have boomed, but haven't been severely tested as now. Investors are learning that activities often taken for granted in established arenas such as the stock market -- knowing the price of an investment, for example -- can go bonkers in the world of derivatives.
Commercial-paper markets became caught up in some of these trends during the past week. Commercial paper, a staple investment for money-market mutual funds, are short-term loans typically issued by highly rated companies for less than a year. The market -- $2 trillion in the U.S. and nearly $1 trillion in Europe -- is considered one of the most easily traded and safest corners of the financial markets outside of U.S. government bonds.
But interest rates on commercial paper have risen as far and as fast as they did after the shock of the Sept. 11, 2001, terror attacks.
Behind the surge: Banks that typically lend to each other in this market were withholding loans to preserve money in case they needed to back up affiliates. Some European banks were facing credit squeezes because their affiliates might be exposed to U.S. subprime mortgages, bankers and traders say.
The commercial-paper problems hit Europe particularly hard. Investors worried that some European banks were exposed to U.S. subprime mortgages, particularly after German bank IKB Deutsche Industriebank AG disclosed on July 30 that its profits would be hurt by subprime exposure.
"It shows that there are so many interconnections today between different parts of the market that otherwise seem so disparate," says Eric Jacobson, director of fixed-income strategies at Chicago research firm Morningstar Inc.
The credit-default swap market also is a source of some concern. Investors increasingly turn to this market to make bets on the fortunes of companies, and to hedge themselves against the risk of a default. In the past few weeks, volume in indexes that track these derivatives has more than tripled, according to data from Deutsche Bank. By contrast, the so-called cash market, where the loans and bonds of individual companies exchange hands, has become almost totally frozen.
After trading a credit-default swap -- which banks exchange with investors, hedge funds and other financial institutions -- banks need to input the trade details into their internal computer systems and confirm the terms between parties. In 2005, regulators demanded that banks clean up huge backlogs in documenting these trades in this booming market, and they have made solid progress toward doing so.
The Federal Reserve Bank of New York demanded that banks clean up these backlogs in part because it worried dealers could lose track of who owes what to whom. Officials also worried that a backlog of unconfirmed trades could be called into question in times of market stress.
But Citi's London credit-derivatives office hasn't been inputting terms fast enough to keep up with high trading volumes in at least one of its markets, according to people familiar with the matter. As a result, a backlog of unprocessed trades has built again, they said.
"Based on industry metrics, our credit derivatives trade-confirmation and settlement activity is very much in line with the rest of the industry. We have heard no complaints from our clients," a Citigroup spokesman said.
As demand for credit derivatives increases, the market has become subject to other strains. In the face of huge price swings and a growing aversion to risk, it has become more difficult to execute trades. That is what traders refer to as liquidity risk; it may mean both dealers and hedge funds that thought they could get out of positions or hedge those same positions may be left with large exposures.
Indexes that track this market have swung widely in recent weeks. The volume of trades some dealers are willing to buy and sell have shrunk drastically, both dealers and their hedge-fund clients say. Both sides add that there is also a huge gap between the prices buyers say they will pay and the prices sellers say they will take. That further discourages orders.
Meanwhile, the Securities and Exchange Commission is worried about how the market is handling another kind of derivative called collateralized-debt obligations.
Securities regulators are checking the books at top Wall Street brokerage firms and banks to make sure they aren't hiding losses in the subprime-mortgage meltdown, said people familiar with the inquiry. The SEC is looking into whether Wall Street brokers are using consistent methods to calculate the value of subprime-mortgage assets in their own inventories, as well as assets held for customers such as hedge funds, these same people said. The concern is that the firms may not be marking down their inventory as aggressively enough.
The broader problem for the market is that trading in many of these instruments is so sparse, it has become increasingly difficult for investors and investment banks to put an accurate value on them.
Writing in the Financial Times, author and law school professor Frank Partnoy describes an even more fundamental problem with synthetic securities in "The Derivatives Vacuum."
The recent collapse of two hedge funds at Bear Stearns Asset Management raises two questions few people can answer. How did they lose so much money so quickly? And where else are similar problems buried? The unsatisfying answers illustrate why markets suddenly have become so volatile.
First, it has been widely reported that the Bear Stearns hedge funds lost money on highly rated derivative securities based on subprime mortgages. Essentially, these securities, known as collateralised debt obligations (CDOs), were complex bets on how many people would repay the money they borrowed to buy homes. Although Bear Stearns has not yet admitted which versions of these derivatives it held, one can glean some characteristics from letters the funds sent to investors months ago.
On May 15, the newer of the two funds reported it was down 6.5 per cent for the year. By contrast, the value of many subprime-linked securities had been sliced in half as early as February. In other words, the fund was not simply tracking the subprime markets: it was doing better, presumably because it was buying highly rated securities. Still, many investors in both funds were nervous about the losses and asked to redeem their investments. The funds said No.
On June 7, losses climbed to 19 per cent. Investors asked how the newer fund lost so much money, when the subprime markets were rebounding and many commentators, including Ben Bernanke, the Federal Reserve chairman, suggested a crisis had been avoided. Indeed, as the markets bubbled with optimism at the time, Everquest Financial, a new firm that had purchased most of its $700m of assets from the two Bear Stearns funds, filed for an initial public offering. This timing was baffling: why did the two funds fall while the markets rose?
Then came the whopper: on July 18, Bear Stearns admitted it could not figure out how much money it had lost. It said: “A team at BSAM [Bear Stearns Asset Management] has been working diligently to calculate the 2007 month-end performance for both May and June for the funds.” The funds refused to answer investors’ questions. Less than two weeks later, they filed for bankruptcy protection.
Bankers Trust, the most sophisticated derivatives firm of the 1990s, made similar mistakes. In 2001, the chief executive of American Express shocked investors when he admitted the company “did not comprehend the risk” when it lost $826m on CDOs. Freddie Mac and Fannie Mae have taken years to value derivatives losses, as did Enron.
As in those cases, the Bear Stearns funds did not lose money in the manner most people think. If the funds lost most of their money in May and June, they must have held positions other than highly rated CDOs. Some experts say the funds also made lower-rated subprime bets that were designed to hedge risk by moving in the opposite direction. Unfortunately, they did not. The Bear Stearns funds held opposing positions that unexpectedly moved in the same direction. As many traders say, the only perfect hedge is in a Japanese garden.
Anyone looking for clues to buried subprime losses elsewhere also should understand that many institutions do not “mark to market” complex derivatives to reflect changes in value over time. Many pension funds and insurance companies hold subprime-linked derivatives, but have not yet recorded losses. Others have recorded some, but not all, losses. Indeed, it is possible the Bear Stearns funds lost money during February, but did not record those losses until months later.
Some institutions argue that accounting rules permit them to hold derivatives at cost. Others say they need not reflect a loss until there is compelling evidence of a decline in value, such as a downgrade of the investments’ credit rating. As a result, it is virtually impossible for investors to understand how much exposure an institution really has to the subprime markets.
The common denominator of derivatives fiascos such as that of the Bear Stearns funds is that the answer to the above questions is: “No one knows.” Subprime exposure can remain buried and unexplained for months.
Now that investors seem to understand this, the markets are swinging wildly. Volatility is highest when people realise they cannot figure out what investments are worth.
Former Federal Reserve Chairman Alan Greenspan once said that "the clearest evidence of the perceived benefits that derivatives have provided is their continued spectacular growth." Based on the carnage that a huge build-up of unsaleable derivatives has helped to create in global financial markets, it seems that's one more thing "the maestro" has gotten wrong.
www.financialarmageddon.com/
I have listed some of the highlights:
-As investors have shunned risk, trading in some markets has dried up.
-The biggest immediate issue: a jump in short-term interest rates as banks became unwilling to make cash readily available to borrowers was met Friday by the Central Banks
-knowing the price of an investment, for example -- can go bonkers in the world of derivatives
-regulators are probing the balance sheets of some U.S. investment banks to check whether they have been accurately recording the values of some derivative holdings
-it has become more difficult to execute trades
-Commercial-paper markets became caught up in some of these trends during the past week
-In the past few weeks, volume in indexes that track these derivatives has more than tripled, according to data from Deutsche Bank. By contrast, the so-called cash market, where the loans and bonds of individual companies exchange hands, has become almost totally frozen.
-This is not the first time smart people have bought complex derivatives and later said they could not calculate their losses.
-it is virtually impossible for investors to understand how much exposure an institution really has to the subprime markets
-Subprime exposure can remain buried and unexplained for months