THE DERIVATIVES MESS Final Part Robert Chapman 15 December 1998
Brooksley Born, CFTC Chairwoman, has been against all odds, trying to
get OTC-derivatives regulations, but Congress, the Treasury, the SEC and
the FED have stopped her. You talk about a conspiratorial cabal. Banks
have gotten filthy rich off derivatives and, of course, cheap give away
money from the FED. Born says, "we are the only federal agency with
statutory authority to regulate hedge funds and a certain portion of the
swaps market" and she is right. It should be noted Richard Lindsay of
the SEC said, "uncertainty created by concerns about the imposition of
new regulatory costs may stifle innovation and push transactions
offshore." Alan Greenspan testified that "no doubt derivatives loses
will mushroom at the next significant downturn" he nevertheless saw "no
reason to question the underlying stability of OTC markets, or the
overall effectiveness of private-market discipline, or the prudential
supervision of the derivatives activities of banks and other regulated
participants." They knew we would have major hedge fund or bank
failures, but were unwilling to do anything to stop it, so banks and
their clients, hedge funds, could continue to enrich themselves and
destroy whichever economy or country they were directed too. It is not
only the money these entities made, but the destruction and
recolonization of countries throughout the world. The operation was one
of financial and political warfare, a context our kept media dares not
discuss.
Just to show you how dishonest and corrupt Congress is during this stock
market correction and hedge fund debacle, the House and Senate agreed on
Monday 9/27/98 to a six-month moratorium of any expansion of
OTC-derivatives authority for the CFTC. This follows a one-year
moratorium. Now we ask you, does this smack of cronyism? This moratorium
was backed by Senator Robert Smith (R-Ore.) and Senator Richard Lugar
(R.Ind.), Chairmen of the Congressional Agriculture Committees that
oversee the CFTC. You might write and ask them to explain such behavior
in the midst of a multi-trillion dollar crises. Of course, the banks,
brokerage houses, hedge funds, the Treasury and the FED were jubilant.
Let the looting continue.
The point everyone misses is buying derivatives is not investing. It is
gambling, insurance and high stakes bookmaking. Derivatives create
nothing. Rick Grove, top man at the International Swaps and Derivatives
Association defends the lack of legislation contending it inhibits
investment. What investment? Thus hedge funds will be studied to death
and legislation will be forthcoming when it is too late and the world's
financial markets will have collapsed.
Recent volatile markets have allowed market makers to again cheat buyers
and sellers. Orders are being broken into pieces and being scaled up for
buyers and down for sellers and with little or no regulation they can do
as they please. Many traders have been running naked, having avoided
hedging options they sold, because contracts were too expensive to be
effective hedges. Stocks have fallen so much, that many traders lost
money. Some will go out of business.
Finally Alan Greenspan painted a frightening picture of the potential
damage LTCM's failure could have inflicted in an address to Congress on
Oct. 1. He said, "on occasion there will be mistakes made, as there were
in LTCM and I will forecast without knowing who, what or where, that
there will be many more. I would suspect there are potential disasters
running into a very large number, in the hundreds." Where has Greenspan
been for the last six years as the derivative problem was building to a
climax? We were one of only three publications, that we know of, that
consistently warned the world public of the impending problem. With all
of this said, Greenspan said he didn't think more regulations would
work, using the old canard that the funds would go offshore. Legislators
responded by saying oversight was lax and that the bailout was an
improper helping hand to rich speculators. Jim Leach (R.Iowa), who is a
darling of the banks, suggested that the consortium violated anti-trust
laws and questioned its financial concentration. He urged the Justice
Department to review the bailout. John Meriwether was a consummate Wall
Street insider who manipulated the FED and was able, through whatever
devices, to coax billions of dollars in uncollateralized loans from Wall
Street. Why was LTCM leveraged some 300 times its capital base? Why was
Warren Buffett's offer rejected? He was willing to put up $4 billion
with $3.75 billion going to run the portfolio. The cartel put up $3.65
billion for 90% of the fund, leaving principals and investors with a 10%
stake, worth $405 million. That left Meriwether and crew with almost
twice as much as the truly private bid they turned down. The principal
beneficiaries of the rescue, however, were the lenders who advanced the
money that built the 300 to 1 leverage. This exercise in crony
capitalism, this sweet heart deal, was used to pay deferred management
fees that were owed the management company that created the disaster.
The fees were used to pay off a $38 million inter company loan, another
$50 million loan owed to a bank that was part of the consortium and
about $7 million in non-partner deferred employee compensation. The
bailout was a back-room deal.
Russia's debt moratorium has forced restructuring of its Treasury bill
(GKO) market and has sparked a flood of disputes between western banks
over repayment of debts associated with their holdings of such
ruble-denominated debt. Derivative protection bought from Russian banks
to protect investments is worthless since the government declared a
90-day moratorium and there is no reference rate for the ruble. The
derivative credit default swaps at issue should be paid out, because a
moratorium is a default. But in a criminal society it might mean
something else.
There is growing concern over the credit profile of some of the world's
top banks and it has sparked a demand for credit derivatives to insure
against possible loan defaults and to limit exposure to these banks.
Banks are also taking out protection against each other as a perception
grows that they need to insure against banks failing to repay anything
from commercial loans to bonds issued by banks themselves. Premiums for
AA rated European banks has widened by 1/2% in the last two months due
to exposure to Russian and emerging market debt. Credit risk is
everywhere. The total outstanding value of credit derivatives is
expected to jump to $350 billion by the end of this year and reach $740
billion by 2000. Who writes this insurance and how solvent are they?
There are few publications in the world where you can get this kind of
information early enough to protect yourself. What the biggest banks in
the world are saying is we could all go under. That is right, the credit
system could well collapse. The answer is to have small denomination
U.S. currency, gold and silver coins and stocks and food and protection.
You may well need them if panicking bankers are any indication.
Lipper Analytical Services, says the best performing equity fund in the
work, is a hedge fund called Lancer Voyager Fund. Their data base shows
assets of $30 million, but no information on what those assets are.
Lancer is promoted to the public by web site from So. Africa. If one
accesses the Edgar Online web site their securities are shown to be
illiquid, highly speculative and of dubious promise. All Lancer does is
promote 122% growth in 1997 failing to disclose what their portfolio
holds, unless you hunt for it. Only Lancer knows for sure what is in its
portfolio. Investors, unless an investment has fully and total
transparency, don't buy it.
The BIS survey says, buying and selling of the dollar accounts for 85%
of total turnover in London, the world's leading center forforeign
exchange. Forty percent of those trades are dollar-euro trades. Turnover
in New York has grown 43% since 1995 or an average of $351 billion a day
in April versus $224 billion in 1995. In N.Y. swaps accounted for 47% of
the foreign exchange volume compared to 42% spot volume. Foreign
exchange and interest rate derivatives have increased 75% in 3 years,
compared to a 42% increase in spot volume. London OTC derivative
currency trading rose 131%. London overall volume is double that of N.Y.
This shows you the real derivative exposure and problems could be twice
as bad in London than in N.Y.
The exposure of derivative losses continues. Cargill, member of the
commodity cartel, lost $200 million. Brooksley Born, head of the CFTC,
has called for more transparency in OTC derivatives by demanding more
information for creditors and counter parties and the reporting of
certain positions to federal regulators. The LTCM, registered with the
CFTC, is being investigated. She said, regulators needed to address the
issue of excessive leverage by hedge funds and insufficient prudential
controls. An Ohio hospital was awarded $21.5 million in arbitration
against Kidder Peabody regarding derivative transactions. Turnover in
the OTC derivative market soared by 85% since 1995. The D-mark has
overtaken the dollar as the most important currency in OTC rate swap
transactions with 30% of the market. Volume has risen seven fold. George
Soros is shutting down his emerging markets hedge fund Quantum Fund,
which lost 31% of its value this year.
The explosive growth of credit derivatives is causing great concern.
Some banks may be exposed to significant risks they still do not fully
understand. Credit derivatives allow investors worried that a borrower
may default or a bond may not be repaid to sell the risk to a third
party. Essentially an insurance or bookmaking transaction. The global
market for credit derivatives will grow from $180 billion in 1997 to
$740 billion in 2000. Experts say there are dangerous hidden risks and
that the market has moved far beyond the present, almost non-existent,
regulatory environment.
Credit default swaps offers insurance against defaults and total return
swaps allow an institution to acquire the cash flows of a bond or other
investment without holding the instrument physically. The big buyers are
banks, insurance companies and corporations. Both vehicles carry a
predetermined premium calculated on the perceived risk. Analysts say
there is insufficient liquidity in the credit default swap market to be
able to extract enough information about default probability for pricing
purposes. There is no model for pricing because the information about
default probability isn't there. Who knows the price of a defaulted
asset? Then there is the risk of the sellers. Buyers cannot be sure
they'll remain in business. Buyers cannot always be sure they are
risk-free, such as large hedge funds, which borrow heavily to fund risky
positions.
The whole use of derivatives as hedging instruments has come into doubt
because many of the counter parties have become dubious. There is a risk
of a chain reaction through the entire system. The contracts and terms
used, from country to country, in derivatives are wide open to
conflicting interpretation, particularly when it comes to determining if
a credit event has occurred, such as with Russian banks. A moratorium
has been called. The banks won't pay because they say that doesn't
constitute a default. As you can see derivatives can be classed with
land mines. You never know when you'll step into the wrong one and be
destroyed. Julian Robertson said, his Tiger funds had lost 17%, or $3.4
billion through October and he has reduced his debt ratio to 4 to 1. The
large cash position is to meet potential demands for more collateral
from lenders and requests by investors to cash out at year-end. The 450
investors at the annual meeting were feted to a sumptuous gala diner and
dance at the Metropolitan Museum of Art. Speaking was Dame Margaret
Thatcher, a Tiger board member.
Over the past few years we have warned repeatedly that the derivative
markets would be the undoing of the financial system. We just had the
first close call with LTCM. In spite of the fact Brooksley Born,
chairman of the CFTC, is a long time friend of Hillary Clinton, we think
she's done a great job over the past year of warning Congress and the
public that OTC derivatives were out of control. Arthur Levitt, Robert
Rubin, Alan Greenspan and a purchased Congress have tried to muzzle her,
much as they did Henry Gonzalez when he confronted the Fed. Then came
the LTCM collapse of Fed sponsored bailouts which rocked already-shaky
world financial markets. Ms. Born has resisted intense pressure to back
off but hasn't done so. This is the woman who almost became
Attorney-General. Ms. Born is an idealist who isn't going to back down.
That is until she's told, if you don't, you'll have some very permanent
problems.
There is absolutely no regulation or control of the privately traded OTC
derivatives market. All those instruments have little collateral, they
are off balance sheet and their complexity makes monitoring them
extremely difficult, as we've seen with LTCM. If one goes they could all
go and bring down the whole financial system. That is why rules and
regulations are needed. Alan Greenspan contends hedge funds and others
are sophisticated investors and lenders already provide plenty of
oversight in the interest of prtraded OTC derivatives market. All those
instruments have little collateral, they are off balance sheet and their
complexity makes monitoring them extre
Afterword:
Reuters reports that UBS entered into its investment with LTCM knowing
its leverage was 250 times, breaching the Swiss bank's own guidelines of
30 times, which we consider preposterous. UBS invested $800 million,
wrote off $733 million and contributed $300 million to LTCM's rescue.
UBS said, "given the very high leverage, we must place great reliance on
LTCM's risk management and controls. The business imperative is that
this is an important trading counter-party for the bank." LTCM had eight
strategic investors, "generally government owned banks in major
markets," which owned 30.9% of its capital. They gave LTCM "a window to
see the structural changes occurring in these markets to which the
strategic investors belong."
There you have it. The Fed was bailing out central banks who owned
almost 1/3 of the fund. As you can see UBS and others were also involved
with LTCM because they were able to see central bank moves prior to
their being known by the public, which is called inside information. |
