I think this has a lot to do with what is going on.
The King Report
M. Ramsey King Securities, Inc.
Tuesday March 7, 2006 - Issue 3342 "Independent View of the News"
Yesterday was a very rare day - everything was for sale. Bonds, stocks, gold, oil, silver, commodities and foreign currencies were sold (making the dollar rally). This is the liquidation of the cash is trash trade.
WHY, why now are traders and investors abandoning the principal trade orthodoxy that has lasted for years? Are increasing global interest rates finally starting to bite? Maybe the inexorable decline in US housing statistics and the rally in long-term bond yields have brought 'religion' to the markets. Now the yield curve is acting like the traditional inversion that presages recession - long rates are finally increasing with short rates. But short rates have not yet increased faster than long rates…If the Fed hikes to 5%, it will be interesting to see if the yield curve inverts or remains somewhat flat.
These are just some of the potholes that exist under the markets. However, there is an abyss under the markets, and we cannot fathom why investment professionals are not more concerned.
The abyss is the derivative mess. We have commented often about this; and last week we highlighted the concern expressed by NY Fed President & CEO, Timothy Geithner. Our friend Pat alerted us to the Comstock Partners' missive, The Derivative Mess, about Geithner's dire commentary on derivatives.
Mr. Geithner on the derivative mess: Derivatives "have not eliminated risk." "We know less about how these markets will function in conditions of stress, and the most sophisticated tools available for measuring potential losses have less to offer than they will with the benefit of experience with adversity." (see LTCM) We have noted that CDS have increased the risk in GM debt almost 7 fold - from $30B of GM debt to $200B in derivatives on that debt…Geithner asserts that the incredible derivative growth has occurred in a benign environment.
Here are the bombshells: "The total stock of unconfirmed trades is large and until recently was growing considerably faster than the total volume of transactions." This is incredible. If this occurred in the stock or bond market, the markets would stop functioning. How can the regulators and solons allow this to continue?
But the situation is even worse than unconfirmed trades. "..firms were typically assigning trades without the knowledge of consent of the original counterparties."
comstockfunds.com
This is similar to what occurred in the '70s in the OTC market during violent moves. Over-worked trade processors randomly assigned counterparties to trades. More importantly, a number of traders concealed losing trades during these periods of back office confusion. Traders 'hid tickets' by assigning fraudulent counterparties to losing trades.
When the back office would notify the trader with 'Goldman is DKing your QXYZ purchase', the trader would respond, 'The trade was with Loeb.' A week or so later, the back office would say, 'Loeb is DKing your trade. The trader would then pick another dealer. This would go on until someone figured out the scheme. We saw similar problems on the CBOE during the market violence that occurred in October '79 when Volcker instituted the quantitative tightening and in March '80 during the Hunt Brothers debacle. Ergo, brokerage firms, banks, hedgies and other entities that trade large amounts of derivatives probably don't have a handle on exposure or risk.
But it gets even worse. "Nostro trades, which are errors in payments discovered by counterparties at the time of quarterly flows, rose to a significant share of total trades…the assignment problems create uncertainty about the actual size of exposures to individual counterparties that could exacerbate market liquidity problems in the event of stress."
This is nuts! The $300 TRILLION+ ($11Trillion+ in '05) derivative market cannot fully know exposure or risk levels. AND payment errors, which we assume include dividends, coupon payments, interest, etc., are "a significant share of total trades." This suggests that earnings/performance at brokers, banks, hedge funds and trading firms that engage in significant derivative activity are not accurate.
Furthermore, if the NY Fed President pontificates this negatively about derivatives, what is the real story? Officials seldom divulge the full magnitude of problems.
We have bashed Easy Al for years on his 'don't ask, don't tell, don't scrutinize, don't regulate' policy and pleas. We opined that there is likely only one reason for Al's action. That reason is apparent…
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