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Non-Tech : Derivatives: Darth Vader's Revenge
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To: Peter Singleton who wrote (12)9/2/1998 2:19:00 PM
From: Henry Volquardsen  Read Replies (1) of 2794
 
Hi Peter,

Well there are a number of questions there. As I read the post the question about some bank, let's say LTCB, melting down because of derivatives positions and taking the rest of the system with it is essentailly the cascade risk that was earlier mentioned here regarding Herstatt. The central banks are very attuned to this risk and monitor closely for this type of failure. They have developed a pretty rapid response technique and make sure that the major participants realize they will have full liquidity support. This has been tested several times. The one that springs most readily to mind is the Penn Square Bank out of Oklahoma in the early 80s. This bank was a huge loan originator with a pipeline to Chase and Continental Illinois. It failed rather spectacularly and threatened just the type of cascading liquidity failures as Herstatt. The Fed stepped into the breach and provided liquidity to the system and prevented the failures.

Also cross bank risks have been limited by factors such as payment netting. If we had payment netting in the 70s, Herstatt would not have had as much of an impact.

Also Howard is correct the cash (I use the term economic) exposure being less than the notional exposure. Plus there is a lot of positions going in both directions. I have had a lot of dealings with Japanese banks. I am not concerned about their derivatives exposure. Their straight forward bad loans are a much bigger problem.

Re the last question about what happens to our puts etc. That is actually a question. I wonder how many people with options positions on the various futures exchanges have ever checked the credit worthiness of the exchanges.

Fwiw, I am not a subscriber to the 29-32 meltdown/global depression scenario.

Henry
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