I'd like to post this as a letter, and private correspondence only.
With perhaps a few random quotes thrown in.
(C) WSJ Co.
thoughts in an article by Kathryn M. Welling...Why Worry? (Sept. 221, 1998, Barron's)
"... Julian Robertson...owned up to paper losses (largely on bets against the yen) of about $2.1 billion, or about 10% of his hedge fund's assets, in just the first two weeks of this month -- on top of previously reported August losses of about $600 million on ruble-denominated bonds. Portfolio losses are something that Julian famously doesn't take lightly, and his fund's recent incursions into red-ink territory are no exception.....there'll be plenty more punishment to go around in the current market environment -- for both good and bad investors. "But only the good will survive." Julian left little doubt, to be sure, which camp Tiger is in.
...he has distinct ideas about who may not prove so lucky. And that he believes that the cultural fault lines in the brave new era of globalization -- so unceremoniously exposed amid the current upheaval in markets from Thailand to Brazil -- not only won't easily be papered over but still pose serious risks. In large measure, because of what might charitably be called a lack of candor about their losses on the part of some major financial institutions, particularly in Europe. The fascinating thing, Julian says, about the negotiations that resulted in what he ruefully calls the "agreement" Tiger hammered out to extricate itself from its ruble exposure was that they stalled for a painfully long time over the insistence, by the European banks involved, that they'd take only "non-tradable bonds."
"Naive us," recounts Julian. "It finally dawned on us that what they wanted was something that couldn't be marked to market."
Deutschebank in particular has raised Julian's hackles. The German banking giant's supreme leader, he reports, has dismissed questions about losses on its Russian exposure as "rubbish." Which is rubbish indeed, says Julian. "We know they got killed."
How badly is something that a bank spokesman says it is not ready to discuss. But it strikes us that, in current conditions, questions about specific portfolios' exposures -- while packed with all the prurient interest of the Starr report -- are perhaps less significant than the "macro" impact they're having in deflating the global economy.
....Andrew Smithers' take on the issue... the exact dollars or yen or D-marks of damage is nigh impossible, says Andrew, whose London-based economic consulting group, Smithers & Co., advises international fund managers. Not much noticed while the only direction in which the markets traveled was up, it has become painfully apparent in the past year that the globalization of portfolio flows sped far ahead of the spread of "transparency" or adequate standards of disclosure to investors.
Nonetheless, some reasonable back-of-the-envelope estimates can be made. With world GDP at about $30 trillion, Andrew reckons -- based on the relationship between GDP and money supply in the G-7 industrialized nations -- that $30 trillion is also a workable estimate of the amount of money sloshing around the globe. From there, using a rough average of 5% Tier One capital, he arrives at a ballpark figure of $1.5 trillion of total equity capital in the global banking system.
Which certainly sounds like a comfortable cushion. Or is it?
Says Andrew, "If current estimates are right and banks have lost $200 billion or so in the combination of recent events in Asia and Russia -- and Fitch has put a $100 billion number on Russia alone -- then the global banking system has probably suffered a contraction of its equity on the order of almost 14%. Which means we must either expect the banks to come to market for more capital -- or see a sharp contraction in their lending activities."
Neither, obviously, is an ideal background for world markets in present circumstances. What's worse, Andrew reckons, is that the $200 billion or so of hits the banking establishment has thus far owned up to could be just the beginning. Especially if "America's financial-asset bubble" pops. The reason: The financial system's immense leverage to derivatives.
Precisely how immense, Andrew ruefully admits, is unknowable.
Consistent reporting standards simply don't exist.
He ought to know. Andrew -- and Cambridge University economist Stephen Wright -- scoured the world looking for ways to get their arms around that information last fall. And he has kept looking, even after publishing their report, which illuminated, for his clients, the potential risk posed to the stock market by just one of the smaller elements of derivativedom: the equity options that have become a favorite instrument of fund managers intent on "neutralizing" market risk in their portfolios.
....It's ... likely that the phenomenal growth in the size of the options market will accentuate the magnitude of any crash set off by other forces. It's also likely to increase the size of the market's price discontinuities -- meaning the extent to which large price movements take place without permitting transactions at intermediate prices."
One of the best things about Andrew's report on equity options was that he put the market risks in context by quantifying, however roughly, options dealers' potential exposures to a nasty ursine turn of events. Which, for argument's sake, he pegged at a sharp 30% decline. The dealers' vulnerability, his report made clear, stems from their consistent failure to take the systemic nature of market risk into account when pricing their "insurance" products. The underpricing of options resulting from this "catastrophe myopia," Andrew reckoned, meant that the major dealers of equity options -- Merrill Lynch, Morgan Stanley, J.P. Morgan, Bankers Trust and Goldman Sachs, which in aggregate had equity of $33 billion -- could have found themselves on the hook for as much as $400 billion.
Granted, while the last six weeks or so haven't been pleasant, the blue-chip averages haven't gone into that sort of a complete swan dive and, in fact, are still clinging to levels that represent declines only about half that steep from their July peaks. And Andrew hasn't rerun his numbers. Yet the yawning gap between a potential derivative exposure of that magnitude and the major brokers' equity bases may go quite a ways towards explaining the 50% and 60% retreats of most of the brokerage stocks from their recent highs.
Even more to the point in a global context, as Andrew reminded us when we rang him up the other day, is that the value of the outstanding equity options he fussed with in last year's report is positively dwarfed by the volume of swaps, forwards, futures, options, caps, collars and similar derivative exotica carried by a relative handful of the world's major banking and trading institutions. The numbers are mind-boggling. The Comptroller of the Currency's latest report pegged the notional amount of derivatives in the portfolios of U.S.-based banks at $28.2 trillion in the second quarter, 95% of it in the nation's eight largest banks, and the off-balance-sheet credit exposure to derivatives of those banking behemoths at 243% of their risk-based capital.
...for sheer shock value, Andrew is partial to the statistic that Japan's banks sport derivative exposure equal to two quadrillion yen -- a mere four times GDP.
What's of more concern to Andrew, however, is the "weird combination of events" that have vastly increased risk in the derivatives market -- and that threaten incalculable collateral damage to the global economy. "You've had the law of big numbers -- the principle that when people of equal skill play a game of chance, the ones with the most money will win -- operating heavily in the derivatives business for the last few years. The result has been a contraction in the number of people playing the derivatives game.
At the same time, trading in derivatives has been growing four or five times faster than the primary market -- which itself has been expanding four or five times faster than GDP." The upshot is that the big dealers in securities are actually big dealers in derivatives. In other words, there's been a huge concentration of risk in the financial world. And the derivatives that the big banks and brokers are selling, remember, don't insure against specific risk, like auto or fire policies, but against the systemic risk of a market meltdown.
Therefore, warns Andrew, "the chances of a bankruptcy rise day by day. For several reasons: Once you have this concentration of risk, it's increasingly likely there's going to be a movement in the market on any one or two days that is sufficient to bankrupt somebody, even at current levels.
"What's more, as the amount of derivatives in the world expands, the particular amount of market movement needed to produce a failure shrinks. Then, too, over time, the chances of a particularly large stock price movement go from unlikely to a certainty."
In short, says Andrew, "The problem isn't only that the people calling for capital controls are fighting the last war, because banks have now lost enough money to create the opposite problem -- a world in which everyone is scared stiff of lending. The problem is that the chances of a major bankruptcy among financial institutions is rising."
Hope you all study the above carefully. This is more or less what I have been saying for the last month.
Henry any comments?
It seems to me that we are dealing with,"the volume of swaps, forwards, futures, options, caps, collars and similar derivative exotica carried by a relative handful of the world's major banking and trading institutions" and that these financial instruments are subject to not only market risk but event risk and execution risk (assumning the people who engaged in the trade understood the trade...apart from the back office problems of "keeping up")
My best to you,
Clark |
