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Strategies & Market Trends : The Epic American Credit and Bond Bubble Laboratory -- Ignore unavailable to you. Want to Upgrade?

To: benwood who wrote (29919)	4/3/2005 4:03:37 AM
From: shades	Respond to of 110194

"except in our case I expect a derivative meltdown somewhere" contraryinvestor.com As you may recall, 1979 can be characterized as a period where there was no structured finance market. There was no derivatives market. My how times have changed. Could anyone even have imagined in 1979 that in 25 short years the US banking system singularly would be exposed to almost $88 trillion in notional value of derivatives contracts? bis.org In the last quarter of 2004 the combined value of trading in interest rate, stock index and currency contracts on organised exchanges fell by 3%, to $279 trillion. What did it take for LTCM to go BOOM? financialpolicy.org As an indication of the dangers they pose, it is worthwhile recalling a shortened list of recent disasters. Long-Term Capital Management collapsed with $1.4 trillion in derivatives on their books. Sumitomo Bank in Japan used derivatives their manipulation of the global copper market for years prior to 1996. Barings bank, one of the oldest in Europe, was quickly brought to bankruptcy by over a billion dollars in losses from derivatives trading. Both the Mexican financial crisis in 1994 and the East Asian financial crisis of 1997 were exacerbated by the use of derivatives to take large positions on the exchange rate. Most recently, the collapse of a major commodity derivatives dealer Enron Corporation has lead to the largest bankruptcy in U.S. history. The first public interest concerns posed by derivatives comes from the leverage they provide to both hedgers and speculators. Derivatives transactions allow investors to take a large price position in the market while committing only a small amount of capital – thus the use of their capital is leveraged. Derivatives traded in over-the-counter markets have no margin or collateral requirements, and the industry standard has shown to be deeply flawed by recent failures. Leverage makes it cheaper for hedgers to hedge, but it also makes it cheaper to speculate. Instead of buying $1 million of Treasury bonds or $1 million of stock, an investor can buy futures contracts on $1 million of the bonds or stocks with only a few thousand dollars of capital committed as margin (the capital commitment is even smaller in the over-the-counter derivatives markets). The returns from holding the stocks or bonds will be the same as holding the futures on the stocks or bonds. This allows an investor to earn a much higher rate of return on their capital by taking on a much larger amount of risk. Taking on these greater risks raises the likelihood that an investor, even a major financial institution, suffers large losses. If they suffer large losses, then they are threatened with bankruptcy. If they go bankrupt, then the people, banks and other institutions that invested in them or lent money to them will face losses and in turn might face bankruptcy themselves. This spreading of the losses and failures gives rise to systemic risk, and it is an economy wide problem that is made worse by leverage and leveraging instruments such as derivatives. When people suffer damages, even though they were not counterparties or did any business with a failed investor or financial institution, then individual incentives and rules of caveat emptor are not sufficient to protect the public good. In this case, prudential regulation is needed – not to protect fools from themselves, but to protect others from the fools. Another public interest concern involves transparency. Some derivatives are traded on formal futures and options exchanges which are closely regulated. Other derivatives are traded over-the-counter in markets that are almost entirely unregulated. In these non-transparent markets there is very little information provided by either the private market participants or collected by government regulators. Prices and other trading information in these markets is not readily available as is the case with futures and options exchanges. Instead that information is hoarded by each of the market participants. While standard theories of financial markets agree that more transparent markets are more efficient, it requires a public entity to require information be reported and disseminated to the market. As a result of this lack of information in over-the-counter markets, it substantially reduces the ability of the government and other market participants to anticipate and possibly preempt building market pressures, major market failures, or manipulation efforts. Yet another danger involves the use of derivatives to evade, avoid, dodge or out-flank financial market regulations designed to improve economic stability. In the cases of this decade’s financial crises in Mexico and East Asian, the financial institutions in those countries used derivatives to out-flank financial regulations limiting those institutions exposure to foreign exchange risk. Derivatives can also be used to avoid taxation and manipulate accounting rules my restructuring the flow of payments so that earning are reported in one period instead of another. In sum, the enormous derivatives markets are both useful and dangerous. Current method of regulating these markets is not adequate to assure that the markets are safe and sound and that disruptions from these markets do not spill-over into the broader economy. Now if $1.4 trillion of LTCM derivatives blowing up almost sunk us - how much do you think is going to blow up out of the roughly $280 trillion out there right now? 1% 5% 50%? Let's say only 5% blow up - what then?