Carranza thanks for putting up your interesting Bloomberg piece. Splendid...
An Interview with Martin Mayer ... a fragment ...
For the whole interview See:
us1.institutionalriskanalytics.com
The Vigorish of OTC: Interview with Martin Mayer
June 12, 2008 Institutional Risk Analysis
….going back to an earlier point, this preposterous OTC market in things such as credit derivatives, all of those swaps, make you much more dependent upon the quality of your counterparty.
The IRA: The credit quality of counterparties is never explicitly priced into an OTC swap and, in theory, is instead addressed within the bilateral relationship with the dealer!
We have shifted the risk from the aggregate level via exchanges to individual firms, thus the failure of BSC and the near-miss for LEH, which apparently is still ongoing.
Mayer: Of course. Everybody says that the trillions of dollars in notional exposure in OTC markets like CDS are not important, but within these notional amounts are counterparty relationships that have weak links.
The IRA: Yes, when an OTC trade fails the notional amount becomes very important.
Mayer: That's right. Suddenly for somebody that notional amount becomes real.
The IRA: This is one reason why we have been so vocal about the situation with Bank of America (NYSE:BAC) acquisition of Countrywide Financial (NYSE:CFC). If BAC goes ahead with the transaction, then the cost of dealing with CFCs total liabilities, including litigation, may force a bankruptcy of the non-bank operations of CFC. BAC has said as much repeatedly. Obviously the Fed wants the deal to close because the alternative to a purchase, namely the takeover of CFC's bank unit by the FDIC opens many cans of worms, including the prospect of the FDIC abrogating swap contracts which flow through the bank. Acting as receiver, the FDIC has unilateral power to revise or reject contracts by a failed bank. The party expecting to receive in a swap contract might find themselves as general creditors of a bank resolution.
Mayer: They have put the derivatives contracts ahead of the other creditors, by law.
The IRA: Yes, the parties to a netting agreement are exempt from the automatic stay in bankruptcy. But going back to your point about the notional amount being important, the happy squirrels at ISDA thought that they could protect OTC derivatives trades by getting an exemption to the automatic stay. But that outcome assumes that there is sufficient money available to make the payment. If the moneys are insufficient, then the receiving party will end up filing a claim in bankruptcy -- unless the Fed bails everyone out.
Mayer: I keep wondering how banks like Citigroup (NYSE:C) and others managed to get all of that money out of the Persian Gulf states. Maybe that Saudi prince who rescued Citi before made money at it. But they are not going to make money this time. We have not been very good at allocating losses. We do them on the sly and then try to inflate them away. But I don't think that we can do that now.
there does not seem to be any inflation possible on the wage front. US consumers are only losing purchasing power due to global free trade. In terms of wages, the US faces continued deflation, so this can't help the overall credit standing of the US economy. But going back to the OTC issue, how do we fix the illiquidity in the financial markets?
Mayer: In the second edition of The Bankers, about two thirds of the way through, I promulgated three laws of financial derivatives. The first law is that when the whole is priced to sell for less than the sum of the parts, some of the parts are overpriced. Second law is that when you segment value you segment liquidity.
The IRA: So much for innovation.
Mayer: And the third law is that risk shifting instruments will tend over time to shift risk unto those less able to bear it because them what's got want to keep and hedge, and them that ain't got want to bet and speculate. Three laws from the 1990s and all three still true. This business about appetite for risk or ability to shift risk is all crap. The banks and funds own some of this junk, but not so much. They don't seem to be howling nearly so much as the guy who packaged these assets and stupidly kept inventory.
The IRA. Correct. We can recall years ago bugging BSC CEO Alan Schwartz about our bank risk tools. His response was that we don't take much counterparty risk. Our only risk is our mortgage conduit. That turned out to be a very prophetic statement. The firms that got into packaging have been among those hurt the most by the downturn.
Mayer: Besides the liquidity issue, the dealers developed an appetite for the higher yielding tranches of these deals. But when you think about it, that shows such a lack of understanding of the business! |
