30 replies to this topic

[Cuthbert Calculus]

A concise version of Dr Bubb's derivatives piece has been published on the MOneyweek website:

http://www.moneyweek...-to-us-all.aspx

(excerpt- added in edit by Dr.Bubb):



A better understanding of OTC derivatives is vital to us all / Jul 07, 2008

A popular candidate for the next big problem is the 'over-the-counter' (OTC) derivatives books of the banks. Many articles have been written about how huge these exposures are, and how losses in this area may trigger an even larger crisis in the global financial system. A meltdown could happen, but if it did, it might simply occur because fear spins out of control, and the desire to stop doing bad business prevents the banks from doing any business at all. A frozen financial sector would create huge problems for the US and for the global economy, and may even trigger a depression. But it need not happen. As Franklin Delano Roosevelt once put it in the depths of the 1930's depression, "The only thing we have to fear is fear itself." Panic can be avoided, provided the risks are better understood and better managed.

Risk on OTC derivatives is not easy to extinguish, and gets over-counted

Original article (w/o the sidebar): http://www.financial.../2008/0605.html

[littledavesab]

I read the original on Financial Sense over the weekend and it made sense!   Had not realised that back in the day Dr Bubb had single handedly saved the investment banks from  anhialation.........

[littledavesab]

Talking of certain CWR personalitites appearing elsewhere happended to be watching Channel 5 last night about a nice kid with a bionic arm and an American Lady with some device to help her regain her vision

Narrated by a certain Dominic Frisby !

[Cuthbert Calculus]

Well, there you go!

[hotairmail]

Very good Dr Bubb. Well done.

[gudz]

Yep nice1 DrBubb, there more people are made aware, the sooner we can expect this to kick off.
Hopefully with the opposite effect on Gold this time.

It does concern me that Bear Stearns near collapse actually caused Gold to drop. I'd not accounted for selling of Gold positions. Eeeek  

[gudz]

LOL - Just noticed my new Signature - As added by the Mods :-)

Cheers!

[DrBubb]

"A better understanding of OTC derivatives is vital to us all" - Title

(Thanks for organising that, CC.
The MW title works better than the vague and misleading title on Financial Sense : Fighting the Fear
And I am happy to find a link back to GEI)

= = = And here's the ending paragraph:

The next few years will not be easy. Many markets, like housing in the US and UK, remain in bubble territory. Those asset values need to be allowed to deflate. But if banks reform themselves and their reporting in a way that helps to maintain confidence, then we may be spared prices moving in a fear-driven panic, where prices fall below sustainable values, and bring enormous damage to the global financial system.

• By Michael Hampton, July 1, 2008. Visit his website at http://www.globaledgeinvestors.com/

Michael Hampton was a pioneer in introducing oil swaps, an OTC derivative, almost 20 years ago*. He worked in product development for Chase Manhattan Bank at the time, and was a key member of the team that designed the oil swap. He later headed the team that successfully launched the oil swap product throughout Europe. He subsequently headed the commodity derivative business of another big global bank.

==

*for those interested in "Ancient history", here's a link to a best-selling book on Energy Derivatives,
where I contributed the chapter on Energy Options:
http://www.bharatbook.com/detail.asp?id=1314
Managing Energy Price Risk :The New Challenges and Solutions 3rd Edition
"The definitive third edition of the best-selling multi-author reference source on global energy and power markets. Fully revised, updated and extended to incorporate current market realities and theory enabling practitioners to effectively measure, structure, hedge and manage risk in today's energy related transactions:
Summary:
Provides a complete review of the current state of the energy markets, with insights into how leading practitioners, academics and regulators are now tackling the issues and developments"

[DrBubb]

WELCOME to anyone who found their way here thru the Moneyweek article on derivatives.
=======

We are thinking about doing a podcast on it - Any interest ?

[CharlieSays]

WELCOME to anyone who found their way here thru the Moneyweek article on derivatives.
=======

We are thinking about doing a podcast on it - Any interest ?

The article works perfectly on its own, but a podcast on Risk and how to quantify it for your average investor would be interesting, but maybe only to me.

Edit: forgot to say thanks.

[Catflap]

Excellent - keeps building and getting better and better on here.

[DrBubb]

(Apples here - compared with Oranges)


More misleading "analysis" - from people who want to scare you:


What is happening in both the stock and credit markets is a direct result of what's playing out in the CDS market. The Fed could not let Bear Stearns enter bankruptcy because – and only because – the trillions of dollars of credit default swaps on its books would be wiped out. All the banks and institutions that had insurance written by Bear would not be able to say that they were insured or hedged anymore and they would have to write-down billions and billions of dollars in losses that they've been carrying at higher values because they could say that they were insured for those losses.

The counterparty risk that all Bear's trading partners were exposed to was so far and wide, and so deep, that if Bear was to enter bankruptcy it would take years to sort out the risk and losses. That was an untenable option.

The Fed had to bail out Bear Stearns.

The same thing has just happened to AIG . Make no mistake about it, there's nothing wrong with AIG's insurance subsidiaries – absolutely nothing. In fact, the Fed just made the best trade in its history by bailing AIG out and getting equity, warrants and charging the insurance giant seven points over the benchmark London Interbank Offered Rate (LIBOR) on that $85 billion loan!

What happened to AIG is simple: AIG got greedy. AIG, as of June 30, had written $441 billion worth of swaps on corporate bonds, and worse, mortgage-backed securities. As the value of these insured-referenced entities fell, AIG had massive write-downs and additionally had to post more collateral. And when its ratings were downgraded on Monday evening, the company had to post even more collateral, which it didn't have.

In short, what happened in one small AIG corporate subsidiary blew apart the largest insurance company in the world.

But there's more – a lot more. These instruments are causing many of the massive write-downs at banks, investment banks and insurance companies. Knowing what all this means for hedge funds, the credit markets and the stock market is the key to understanding where this might end and how

/see: http://www.marketoracle.co.uk/Article6335.html

[DrBubb]

(GOOD POINTS here-
Swiss regulators tried to make banking more profitable, and instead diminished quality control):

The "Originate to Distribute" Basle Banking Model Created the Banking Crisis
by Christopher M. Quigley, B.Sc., M.M.I.I., M.A., WealthBuilder.ie | September 19, 2008

In an attempt to comprehend the current "credit crisis" I decided to try to investigate its underlying causes. To my dismay I discovered that the situation did not come about by accident but was actually conceived and planned by the International Banking Fraternity in Basel, Switzerland, in 1998.

The tsunami of credit that burst onto the scene after this "Basle Accord" helped save America from a recession, enabled it to fund a war, sleep walked Europeans, politically, into the Euro Zone and attempted to copper fasten the artificial state called the European Union. This crisis is no accident it was premeditated and internationally agreed.

If you don't believe the pre-meditation involved please read the quote below from the Wall Street Journal, Nov. 27th.  2007:

"In 1998 the Basle Accord created the opportunity for regulatory arbitrage whereby banks could shift loans off their balance sheets. A new capital discipline that was designed to “improve” risk management led to a PARALLEL BANKING SYSTEM whose lack of transparency explains how the market started to seize up.

The "originate-to-distribute" model REDUCED THE INCENTIVE for banks to monitor the CREDIT QUALITY of the loans they pumped into collateralized-loan-obligations and other structured vehicles, the rules failed to highlight contingent credit risk......With Basle II, the question is just how the markets will evolve over the next 20 years.... as the new accord will require banks to hold LESS CAPITAL”.

/more: http://www.financialsense.com/fsu/editoria.../2008/0919.html

[Layman]

(Apples here - compared with Oranges)

More misleading "analysis" - from people who want to scare you:

/see: http://www.marketoracle.co.uk/Article6335.html

Bubb, if you can spare the time I'd certainly appreciate a post explaining why you feel this is misleading. I read the article yesterday and thought it sounded highly believable - I guess many others would also.

It'd be interesting to know where you feel it falls down.

[lardoon]

Bubb, if you can spare the time I'd certainly appreciate a post explaining why you feel this is misleading. I read the article yesterday and thought it sounded highly believable - I guess many others would also.

It'd be interesting to know where you feel it falls down.

If I understand correctly - and hopefully the Dr can correct me if I am wrong, but the 516 trillion number is an exaggerated number compared to the reality of the situation (hence comparing oranges to apples: the Dreivatives exposure is not really 10 times the world GDP)
If you read the article on MW:

The key point is this: I believe the huge numbers for OTC derivatives risk that get reported for on the books of banks can be exaggerated. These big totals are mostly 'residual' credit exposures. I say they are exaggerated because in practice, banks have trades in both directions, long and short, with other banks. (That is, bank A may have many open OTC derivative trades with bank B. On some it will be making money, and on some it will be losing money.) These open exposures can be calculated, and netted out, leaving a much, much smaller net credit exposure on the net loss amount due. In other words, the banks will never have to pay the full amount of the OTC derivatives exposure they report, only the net loss amounts. And even those may be dramatically reduced when all the two-way business between the banks is considered.

[DrBubb]

Um... Are We Forgetting Something Here?
by Brian Pretti

It is clear that credit cycle reconciliation events are moving fast. Deleveraging, a theme I have been incessantly harping on almost all year, has clearly kicked into high gear. It’s thought in various circles that Paulson and friends helped engineer the near vertical decline in commodity prices sparked in mid-July. That spark clearly set off a firestorm of hedge liquidation that I believe continues to the present. Following closely behind the commodity price collapse was Fannie and Freddie returning to whom we always knew was their rightful owner – US taxpayers. But when Lehman was allowed to disappear into the night shortly thereafter by the head chefs at the Fed and Treasury, the scramble for liquidity and deleveraging began in earnest on a macro basis. What lay behind this acceleration phenomenon? In part the always hidden and always shrouded derivatives markets. What follows is a snippet from our subscriber site reminding us that amidst the sound, fury, emotion and hysteria of the moment regarding the current bank bailout proposal, there is yet another issue that has not been addressed.

/see: http://www.financialsense.com/Market/pretti/2008/0926.html



(Pretti falls partly into the miscounting trap.  Apart from that, it's a good article):

He DOES recognise that the CASH (ie. profit/loss amounts) are smaller;
"According to our friends at the Bank for International Settlements (BIS), global credit default swaps outstanding total close to $60 trillion in notional value as of the close of the last year. That number has been estimated to be closer to $70 trillion a few months back. Just yesterday, the ISDA (International Swaps and Derivatives Association) told us the volume of trades in the worldwide market for global CDS has fallen to $54.6 trillion due to contract offset activity in the wake of the demise of Bear, Lehman, etc. That’s comforting, right? The BIS estimate of CDS contract cash value as of 2007 YE was $2 trillion. Again, remember that in a potential default-triggering event, these supposed estimated cash values are pocket change relative to potential total cash liabilities created in a defined default. "

But he fails to mention the netting mechanism

He obviously thinks that the risks for CDS (Credit Default Swaps) may be too large to allow confidence to return easily:

From his final comments:
"it will be important to gauge intermediate term financial market reaction once some type of bailout package is passed. But then the hard work begins. Let’s assume relatively illiquid bank assets are swapped for liquidity, the next question for the macro financial sector and the real economy then becomes, will we then have willing lenders and borrowers? ... As a final comment, keep your eye on the credit markets. Although it’s just my opinion, the financial markets, real economy and financial sector will not heal until the credit markets heal. After all, the global credit markets put a definable price on “confidence” each and every day."

[DrBubb]

SEEMS I WAS RIGHT - about Credit Default Swaps cancelling out each other
- or so Don Coxe says...

(excerpt from Basic Points questions):

Your other question was?
SO: It was just regarding the credit default swaps.

DC: Yes. Well by coincidence I spoke to a dinner in New York this week of people in the financial sector
and the fellow next to me at dinner is with one of the three major companies in the world that do the
trading of credit default swaps and they don't do it on a principled basis, they do it on an agency basis and
you may have noticed that there was a leap in the price of one of the other players in this field and so
what I learned was that the unwinding of the Lehman swaps and the expected unwinding of the Wamu
credit default swaps both of which he was very optimistic about, the ultimate fall out that again what
you're going to see is that this is in effect a trailing indicator. Now the credit default swaps are a murky
world to me and I'm not an expert on them but the Lehman unwinding turned out to be a nonevent which
means that the optimists who said that most of these things just cancel each other out because of the fact
that of the way counter parties spread it out back and forth. He explained that to me over dinner.

Now you may say, "Well he is a biased observer because this is one of his main product lines. It's not his
only one," but his view was that this market was improving and that we may be able to stop worrying
about those in a few months also and again frankly there is no way that credit default swaps would be a
reliable investment. They had to be frozen up as long as you had the Ted at those levels because you did
not have any interbank lending going.

So once you get interbank lending at a reasonable level that would tend to reinforce all of these derivative
type markets as long as they aren't derivatives tied directly or indirectly to house prices.

[DrBubb]

The AIG Risk Models Failed, Or Did They?
By David Enke | November 03, 2008 | 11:47 AM | 2 Comments


A recent article in the WSJ discusses the AIG (NYSE: AIG) risk models developed by Gary Gordon, a professor at the Yale School of Management. The headline of the article boldly states "Behind AIG's Fall, Risk Models Failed to Pass Real-World Test." Yet, did the models really fail? Gordon's models were developed to gauge the risk of AIG's credit default swaps, but according to the article, "... AIG didn't anticipate how market forces and contract terms not weighted by the models would turn the swaps, over the short term, into huge financial liabilities." The quote is interesting in that it highlights what may be at the heart of AIG's problems. As a result of its ignorance on whether the short-term collateral risk needed to be considered, or its belief that such risk was not something to be worried about, AIG made a decision to not have Gordon assess these threats - even stating later that it knew his models did not consider such risk. So this begs the question once again. Did the models really fail (as approached by Gordon and approved by AIG), or was it more of a lack of understanding of the very products they were modeling? I know some will ask what's the difference - in the end the models were incomplete - but the distinction is significant.

In hindsight, it is easy to point fingers and wonder exactly what risk AIG was even trying to manage. But the real problem here seems to be less about one particular modeler getting it wrong, or developing incomplete models, and more about management ignoring to consider some risk while putting faith in the very same models that were not designed to give the level of confidence or enterprise-wide coverage that is being used to engender confidence. Even the WSJ article (in the body of the story) mentions how "Mr. Gordon's models harnessed mounds of historical data to focus on the likelihood of default, and his work may indeed prove accurate on that front. But as AIG was aware, his models didn't attempt to measure the risk of future collateral calls or write-downs, which have devastated AIG's finances." Of course, this did not keep AIG from trading as though it did, and therein lies the problem. The failure here is less about modeling, or even risk management, and more about corporate management and decision making. Yet, the perception that the problem is with modeling is widespread. Even Warren Buffett is quoted as saying "All I can say is, beware of geeks .... bearing formulas."

/see: http://www.greenfaucet.com/the-market/the-...-did-they/30835

[littledavesab]

Did the models really fail (as approached by Gordon and approved by AIG), or was it more of a lack of understanding of the very products they were modeling? I know some will ask what's the difference - in the end the models were incomplete - but the distinction is significant.

The failure here is less about modeling, or even risk management, and more about corporate management and decision making. Yet, the perception that the problem is with modeling is widespread. Even Warren Buffett is quoted as saying "All I can say is, beware of geeks .... bearing formulas."

/see: http://www.greenfaucet.com/the-market/the-...-did-they/30835

It still sounds like a risk management failure as risk management should be embedded at the top of an organisation - especially /vitally in an insurance operation  !!!

But Dr B - whats your opion of the other trillions of CDS's out there ?

The currency ones worry me as if they are speculative and knowing how unpredictable currencies are.......   Well you get my drift !

We all know what cgnao thinks.

[DrBubb]

QUOTE ===(littledavesab @ Nov 7 2008) ===
But Dr B - whats your opinion of the other trillions of CDS's out there ?
UNQUOTE =====

90-99% of those huge numbers is nothing more than overcounting,
for the reasons that I mention

But there is a core of genuine risk

Most reports that I read about CDS are nothing more than fear-mongering