The Not Insignificant Probability of a Derivative Accident

August 9, 1999

It was a bearish week on Wall Street. While the Dow did post a 59-point rise, and the Morgan Stanley Cyclical index and utilities gained more than 1%, most other averages were in decline. The S&P 500 was hit for about a 2% loss. The Morgan Stanley Consumer index and Transports slipped 3%. The small caps came under heavy selling pressure with the Russell 2000 declining almost 4%. Technology stocks suffered declines, but actually made it through the week better than we would have expected. The NASDAQ 100 dropped 2 ½% and the Morgan Stanley Technology index declined 2%. The semiconductor stocks continue to outperform, posting a slight gain for the week. The Internets, however, suffered large losses with The Internet index declining 10%. The financial stocks were also hit as investors begin to recognize the deteriorating financial landscape. The S&P Bank index declined 4% and the Bloomberg Wall Street index dropped 6%.

It was another ugly week in the unfolding fixed-income bear market. Yields on the 30-year bond rose eight basis points to 6.18%. Off-the-run bond yields rose even more, to above 6.3%. The 10-year Treasury note, used extensively for hedging and derivative strategies, suffered the heaviest losses as yields rose 14 basis points to 6.04%. Five-year yields rose 12 basis points to 5.91%, with off-the-run 5-year notes now yielding 6%. European bond markets also had a rough week. Today, many instruments traded to yields above June highs and, as has been widely reported in the media, swap spreads have continued to widen significantly, some even beyond levels reached during last year’s financial crisis. In fact, a key swap spread traded yesterday to the widest levels since 1987. As such, we don’t believe today’s decline was as much related to strong employment data, as it was simply more signs of a financial system increasingly on the brink. As we have said before, there is just too much paper and too much leverage.

As we watch a financial crisis unfold right before our eyes and hear market chatter about derivative problems and leveraged players in trouble, we just can’t shake the memory of Alan Greenspan’s speech back in March before the Futures Industry Association. He began by stating: "By far the most significant event in finance during the past decade has been the extraordinary development and expansion of financial derivatives." He continued, "A vast new array of debt, equity and hybrid instruments, as well as newly crafted derivative products have fostered an unbundling of risks, which, in turn, has enabled investors to optimize (as they see it) their portfolios of financial assets. This has engendered a set of market prices and interest rates that have guided business organizations increasingly toward producing those capital investments that offer the highest long-term rates of return, that is, those investments that most closely align themselves with the prospective value preferences of consumers. This process has effectively directed scarce savings into our most potentially valuable productive capital assets. The result, especially in the United States, where financial innovations are most advanced, has been an evident acceleration in productivity and standards of living, and, owing to the financial sector's increased contribution to the process, a greater share of national income earned by it over the past decade. "

Greenspan also threw out some facts: US commercial banks ended 1998 with outstanding derivative positions of $33 trillion, of which $29 trillion were privately arranged over-the-counter (OTC) contracts, hence, outside of government or exchange regulation. This compares to about $460 billion of total equity for the American commercial banking industry. Greenspan also estimated that total OTC derivative positions globally then likely approached $80 trillion, having grown at a 20% compound rate since 1990. According to the International Swaps and Derivative Association, outstanding interest rate swaps, currency swaps and interest rate options grew 76% last year. Estimates now have total derivative positions at over $100 trillion. And, from a report issued in June by the Bank for International Settlements, we see that there were $50 trillion of interest rate derivative contracts outstanding at year-end. Simply astounding - $50 trillion of interest rate derivatives! What on earth has been going on here? Is this actually part of effective risk management and capital allocation as claimed by Greenspan, or is this just financial "sophistication" and wild excess run completely amuck?

Well, we are certainly of the opinion that it is much the latter and believe that Greenspan and other proponents of derivatives just plain have it wrong. In fact, it is our view that this unprecedented proliferation of derivatives has set the stage for a serious crisis, with a not insignificant possibility of a major financial accident. In this regard, it is definitely no coincidence that derivatives have proliferated simultaneously with history’s greatest period of credit excess. Instead of reducing risk, derivatives have been a close accomplice with unprecedented credit growth, creating an historic financial and economic bubble.

And there is no better illustration of the tight interaction between derivatives, credit excesses and the bubble economy than in the workings of mortgage behemoths Fannie Mae and Freddie Mac. As we have mentioned previously, these institutions have aggressively expanded their balance sheets, largely holdings of residential mortgages, from $379 billion at the end of 1994, to almost $870 billion at the end of June. These massive holdings are supported by shareholder’s equity of about $27 billion. Much of this growth was during last year’s mortgage refinancing boom, where American homeowners were offered an incredible opportunity to refinance mortgages at very low rates. For all of 1998, Fannie and Freddie total assets increased $220 billion. To finance these ballooning balance sheets of mortgage holdings, Fannie and Freddie borrowed aggressively from the money markets, and actually ended 1998 with about $400 billion combined short-term debt. One may, understandably, question the wisdom of accepting the interest rate risk inherent with using short-term funding sources for leveraging long-term mortgages. Actually, this is where it gets interesting. Both Fannie and Freddie use derivatives extensively to hedge interest rate risk, and in this regard are likely Wall Street’s best customers. In fact, they are apparently so proficient at "hedging" that Wall Street takes it for granted that they have little interest rate exposure. At the end of last year, Fannie had $170 billion of derivative positions and Freddie Mac had $313 billion, including $220 billion of futures and options, and $42 billion in interest rate swaps.

Looking at how much interest rates have risen since last year when Fannie and Freddie bought all those low-yielding mortgages, they had better hope that they were properly hedged. And, just as important, they better hope that they are able to collect on their winning derivative contracts. In this regard, we can’t help but to remember, and continue to ponder, last year’s fiasco in Russia where many speculators had entered into hedging contracts with Russian banks to protect against a fall in the ruble. Much to everyone’s dismay, however, the ruble was hit with devaluation and the Russian banks were quickly and completely wiped out, defaulting on their derivative contractual obligations. Russia was a textbook case of a derivative market meltdown and counter-party fiasco that should have provided a wakeup call as to the overwhelming systemic risk that is associated with the proliferation of derivatives. This is particularly the case when the derivatives market is dominated by speculators and highly leveraged players. We will certainly place this high on our long list of "lessons that should have been learned." Increasingly, we fear that something quite similar is unfolding in the derivative markets in the US and likely in Europe. Both, clearly, have been hotbeds for the use of derivatives for leveraged speculating.

But let’s get back to Fannie and Freddie. Look at it this way: Since last fall, mortgage-backed securities have lost about 7% of their value. Fannie and Freddie 10-year debt securities have dropped about 10%. So, without hedges, Fannie and Freddie would have suffered huge losses as the value of their mortgage portfolios have dropped significantly. So let’s be conservative and assume that they made 5% on upwards of $400 billion of derivative hedges that offset losses on their mortgages. Well, this means their counterparties owe them $20 billion. Now, if interest rates continue to rise, it is not unrealistic to assume that counterparty obligations could grow, to say $40 billion, and so forth. The problem, remembering back to the Russian bank example, is that Fannie and Freddie have most of their contracts with securities firms. Yet, these firms are themselves acutely vulnerable in today’s environment, with highly leveraged balance sheets and huge exposure to higher rates and a generally tumultuous financial environment. Taking a quick look, and combining five of the major Wall Street firms, Goldman Sachs, Merrill Lynch, Morgan Stanley Dean Witter, Lehman Brothers, and Bear Stearns, we see that they have total assets of $1.3 trillion supported by equity of about $50 billion. And this, importantly, does not include massive off-balance sheet derivative exposure.

The story line here is that sharply rising interest rates very much surprised the Street. Derivative players, with great faith in Greenspan and confidence in models that saw little chance of higher rates, bet wrong and now are potentially on the hook to pay tens of billions, and this just to Fannie and Freddie. If rates rise dramatically from here, these scantly capitalized firms will be hard-pressed to compensate Fannie and Freddie for making all those low-yielding mortgages that will be increasingly underwater. Here, we will use the analogy that Wall Street derivatives dealers have for years acted, and profited handsomely, much as if they were writing flood insurance during a long, and seemingly, endless drought; pocketing premiums that were about as close as it gets to free money. In what must be a harsh reality for many, the drought ended. Now it is raining cats and dogs and the insurers are scurrying around in a near panic at the thought of actually having to pay damage claims. The rocket scientists, armed with the most sophisticated software, always assumed that when the storm clouds formed, they would go out and find some reinsurance and do some hedging. Additionally, such a strategy would also call for major hedging, or purchases of reinsurance, if ever heavy rain began to fall. And, under the worst case scenario, at the first sign of raising river levels, the computer would have the insurer fully reinsured and completely protected against loss. At least this was how it is suppose to work.

But as you can see, the rocket scientist, with his sophisticated flood insurance hedging program, makes some major assumptions, ones that had better be right or there is a big problem. These assumptions include that there will always be a liquid market for reinsurance and that the reinsurers will have the resources to pay in the event of catastrophe. If either of these prove not to be the case, come the flood, the insurance is useless and everyone involved is wiped out. Such erroneous assumptions certainly led to the portfolio insurance debacle during the crash of 1987.

We tend to think that the problem today in the credit markets is that the unfathomable amount of 10’s of trillions of dollars of interest rate insurance has been written and the rain has begun to come down. And actually, it is now coming down real hard and most remain in disbelief that it is really happening, not appreciating that the drought has ended. Certainly, the Wall Street firms that have written hundreds of billions of interest rate contracts to Fannie and Freddie didn’t expect rates to rise like they have. The computer had this as a low probability event. Now, however, these firms are forced to protect themselves, to rush to locate reinsurance. In this event, the computer and sophisticated hedging software called for heavy shorting of Treasury bonds, or better yet, buying derivative protection from one of the other derivative players. To make this all work, the computer had to assume there would always be liquidity to execute these protective hedges. But today, this assumption looks dubious. With rates rising and huge losses for the leveraged speculating community, few, understandably, are interested in jumping in and taking the other side of these types of protective trades. Not only is this not appealing in a faltering marketplace, they already have enough problems of their own to deal with. So, let’s face it, if you have written flood insurance and it is now raining buckets and the river is rising rapidly, it is going to be awfully difficult to find someone to relieve you of your flood insurance risk.

So our financial system has a big problem. Institutions such as Fannie and Freddie, banks, security firms, money managers, pension funds, and corporations throughout our country and throughout the world have purchased trillions of dollars of derivative contracts as insurance against rising rates. They are now going to have claims and expect to get paid. For many, and certainly the case for Fannie and Freddie, if they don’t get paid they will be severely impaired. Yet, we simply can not comprehend who will have the resources to pay if rates continue to rise and losses mount. Certainly, not from the equity of Wall Street firms; they today have big leveraged balance sheets replete with sinking asset values. And as rates rise, the larger the required shorting of securities for hedging, or reinsuring, and the greater the losses for the system as a whole. With liquidity rapidly disappearing, rising rates only leads to greater dislocation and a greater probability of a Russian-style derivative collapse.

We believe today’s higher rates are much the result of derivative hedging programs. Furthermore, it is our belief that sharply widening spreads are the consequence of a lack of liquidity in the securities markets, forcing the panicked derivative players to move to the swaps market for hedges. Market dislocation is further compounded by the heavy losses being suffered by the leveraged speculating community. Certainly, some liquidation has taken place but we are likely approaching the point of heavy forced security sales. And if that wasn’t enough, the booming economy continues to generate incredible demands for borrowings, with a long line of companies waiting to issue debt and a plethora of securitizers with a seemingly endless inventory of loans to bundle and sell. So, the makings for trouble are clear as day: A mountain of securities to be sold and an increasingly illiquid and dislocated financial market environment. The stage is set.

Sure, the bulls just assume that if a problem does develop the Fed will simply lower rates, flood the system with liquidity and let the derivative players off the hook, again. Well, this did work splendidly last fall, but this is anything but a sure thing this time around. There are two critical differences today. First, there is the recognition that the economy is overheated and creating dangerous imbalances. And second, the dollar is in trouble. Importantly, this now leaves the Fed in a quandary and we are not quite sure how they get out of this one. They have certainly created quite a mess. All the same, we would not be surprised by a forceful intervention to support the dollar. This could provide some short-term shock treatment and provide a fleeting boost to both the equity and credit markets. Certainly, the bulls will hope to get through option expiration two weeks from today. With all the equity derivatives that now exist in the marketplace, if we have a serious break next week, the financial markets will have an additional derivative problem to deal with.

Small amounts of natural gold were found in Spanish caves used by the Paleolithic Man about 40,000 B.C.

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