Silicon Valley Watcher - Former FT journalist Tom Foremski reporting from the intersection of technology and media

Must Read Analysis: Why Markets Are Still Falling . . . The Shadow Financial Systems

Posted by Tom Foremski - October 16, 2008

I'm fortunate to be a member of the ACTA Open, which provides great analysis of today's complex financial markets. Here is an excellent analysis by DK Matai, chairman of the ATCA Open. (I'm reprinting it because it is a member only organization - see description at end - but the information should be more widely distributed, imho.)

Why are Markets still Falling? The Tsunami caused by Derivatives and Deleveraging

The invisible elephant in the room causing continuous falls in global financial markets is the link to the privately traded Credit Default Swaps (CDS) and the financial uncertainty they have created whilst synchronised deleveraging takes place across the world. Many CDS contracts have been triggered at their exorbitant notional or face value by a number of bankruptcies and nationalisations and as a result many counterparties are unable to meet their payment obligations which are becoming due week-in week-out in their hundreds of billions of dollars. Much of what is driving the panic in the financial markets is that so little is known about who owes what to whom because of the lack of transparency and no central clearing house for privately traded unregulated derivatives.

Credit default swaps are unregulated financial derivatives which act as debt insurance on risky assets like mortgages, corporate and government bonds. But unlike a normal insurance policy, financial institutions that sell credit default swaps are not required to have enough funds in reserve should those risky loans turn bad. Since the US Congress in 2000 declined to regulate these contracts as it does insurance, the companies that guarantee the assets are not required by law to keep enough capital on hand to pay them off in the event of a default. All that may be about to change. However, evidence suggests more credit default swaps are traded in London than in the United States according to the US Federal Reserve, so US action alone cannot address perceived problems.

As corporations, home owners and credit card holders go into default -- stop making payments -- many financial institutions are being hit twice on their balance sheet -- once by the bad loan and then by the associated CDS default or obligation. This USD 55 trillion problem even at a quarter default, ie, USD 13.75 trillion, is an enormous black hole and equates to nearly 40% of the global equity markets present value at USD 36 trillion. CDS trading has expanded 100-fold since 2001 as financial institutions including insurance companies and hedge funds as well as investors have used the contracts to protect against bond losses and speculate on companies' ability to repay debt. Whilst the credit market was liquid and risk-of-default was relatively low, CDS contracts were cheap to procure: a basis point, or 0.01 percentage point, on a credit-default swap contract protecting USD 10 million of debt from default for five years is equivalent to USD 1,000 a year. Now that the risk is rising, the spreads have widened thereby increasing the value of the original contracts exponentially.

Unlike most financial markets, credit default swaps are unregulated and at USD 54.6 trillion, they are one of the largest unregulated markets in the world. Lawmakers and regulators have called for more oversight of this unregulated market after the bankruptcy of Lehman Brothers, which was among the top 10 counterparties of the contracts. The US government took over New York-based AIG with a USD 85 billion loan to cover obligations at a unit that sold protection on securities through the CDS market. AIG's downfall was triggered when its credit rating was downgraded and it could not post the collateral for which it was obligated under the CDS contracts it had issued. The downfall in the share price of other investment houses and financial institutions including banks, insurance and reinsurance companies is also linked to exposure to toxic assets and the CDS market. There is a clarion call amongst lawmakers to make the terms of credit default swaps transparent and subject to government supervision.

Lawmakers are also considering the introduction of new regulations to curb CDS abuse as engines of speculation, but many financial experts are also encouraging the creation of public exchanges for these shadow markets. An exchange would establish an arms length price. As that price was transparent and moved, the market would see that a credit was deteriorating. A centralised clearing market would help shine a clear light on these transactions and since every trade would be backed up by the members of the clearing house, chances of default would greatly be reduced. There are several organisations that are setting up private exchanges where buyers and sellers can trade credit default swaps. One such initiative is that of the Chicago Mercantile Exchange. They hope to be up and running by the end of 2008.

Creation of a clearinghouse for credit default swaps will reduce the risk posed by the financial derivatives, three US regulatory agencies have said and one of them urged broader reform of Over-The-Counter (OTC) derivatives markets, which is in excess of USD 596 trillion according to the Bank for International Settlements in Basel. Coupled with listed credit derivatives at USD 548 trillion, the 1.144 Quadrillion derivatives market is the invisible equation which helps to create asymmetric leverage and systemic risk. As default on CDS contracts rises, there is a fear that other derivatives settlement could also be affected in the case of those issuers which offer several types of derivatives. Looking forwards, armed with USD 50 trillion by way of global GDP, and assets of the whole world valued at about USD 190 trillion, it is difficult to imagine how world governments will be able to stem the Tsunami caused by collapsing leverage and associated derivatives default even if it is to the tune of 10% of the invisible Quadrillion dollar equation, ie, USD 114 trillion. That number is more than double the number of the global GDP. Recapitalising banks to the tune of USD 4+ trillion worldwide recently still leaves the question of raising those funds via government bonds. The trouble lies in all governments seeking to raise new capital via the bond markets simultaneously. One look at the long dated government bond market suggests that the appetite to buy more government debt is diminishing as yields rise and CDS spreads on the possibility of government debt default tick up. In response to the coming derivatives and deleveraging Tsunami, which has already begun, the world GDP may have to shrink drastically -- some estimates suggest between 30% and 50% -- over the coming years of The Great Unwind. This is the severe recession the markets fear as they go into free fall.

About ACTA Open

The "ATCA Open" network is for professionals interested in ATCA's original global aims, working with ATCA step-by-step across the world, or developing tools supporting ATCA's objectives to build a better world.

The original ATCA -- Asymmetric Threats Contingency Alliance -- is a philanthropic expert initiative founded in 2001 to resolve complex global challenges through collective Socratic dialogue and joint executive action to build a wisdom based global economy.

Adhering to the doctrine of non-violence, ATCA addresses asymmetric threats and social opportunities arising from climate chaos and the environment; radical poverty and microfinance; geo-politics and energy; organised crime & extremism; advanced technologies -- bio, info, nano, robo & AI; demographic skews and resource shortages; pandemics; financial systems and systemic risk; as well as transhumanism and ethics.

Present membership of the original ATCA network is by invitation only and has over 5,000 distinguished members from over 120 countries: including 1,000 Parliamentarians; 1,500 Chairmen and CEOs of corporations; 1,000 Heads of NGOs; 750 Directors at Academic Centres of Excellence; 500 Inventors and Original thinkers; as well as 250 Editors-in-Chief of major media.



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