Henry, thanks for your informed opinion ... incredibly helpful.
Can you comment on the enclosed exhange from the LongWave discussion list? Both of these guys are pretty smart. Howard Hill is a professional trader, and knows derivatives real well. George Ure is, I guess you would say, a professional bear, but a real smart guy in his own right. Hill makes the summation point you make, but George responds with a concern that notational value is at risk in special circumstances.
Peter
George Ure:
Paul Erdman did a piece for CBS marketwatch recently and pointed out the systemic
issue: The real exposure with derivatives is what happens when a derivatives deal
goes south in mid transaction - and the counterparty trade blows up. What seems to
occur is this ripples through the system. It seems likely that the disruption will
"go critical" when a single bank defaults on several counterparty agreements.
Erdman's review involved a German bank that defaulted on trades in process in 1974 and
is worth thinking about. The counterparty offsetting trade can evaporate with a
single default, leaving those huge notional numbers as quite real. In rational
(read:solvent) times counterparty trades limit risk. In "exuberant" (read:like now)
times, counterparty integrity is not a good bet. Too many banks are too weak.
G-1
Howard B. Hill wrote:
> While the notional numbers are huge, the actual cash exposure is small. Most
> postions are laid off with matching trades with another counterparty. Only a few
> participants think they are smart enough to be exposed in these markets. It's
> cross-market "correllations" that can really screw things up. Examples include
> Merrill and JP Morgan writing "prepayment swaps" or options in the the early '90s
> without realizing that historic mortgage prepayment models were out the window
> because of automated refinance marketing and loan underwriting. Historical need
> for 200 basis points advantage fell to 50 basis points, as we probably all
> remember from the cocktail party conversations of '92 and '93 about how many times
> people had refinanced their mortgages.
>
> I doubt the Japanese banks have willingly taken exposures in the derivatives
> markets, other than maybe Nikkei warrants, or maybe yen-dollar forward rate
> agreements.
>
> PeterS7326@aol.com wrote:
>
> > Kit, Stephen,
> >
> > Precisely my point.
> >
> > If the Japanese banks have cumulative derivative exposure greater than the
> > world's GNP, and one (e.g. LTCB) goes down, how do you keep the others from
> > melting down and taking the world financial system with it? This would be the
> > financial event of a thermonuclear reaction.
> >
> > I'm sure there are folks on this thread who understand derivatives and
> > derivative exposure enough to assess how real this danger is. I know I don't.
> >
> > I think we run a risk if we think the worst case financial system scenario is
> > 1929 - 1932 ... with time to make money on the way down. A waterfall crash
> > over a number of months, heralding a global depression, and eventual dollar
> > crash offers lots of chances to take defensive financial positions (and even
> > ones that make money).
> >
> > There's gotta be someone here who understands this well enough to shed some
> > light on the risk of a meltdown so big and so fast that our puts, our cash,
> > our t bills, etc get wiped out along with the long positions in stocks and
> > bonds.
> >
> > Peter |
