Friday, January 25, 2008

WMDs in Financial Markets

Complex Financial Trades Worry Economy Watchers
Rise of Bets Called Swaps Could Worsen Subprime Damage

Even as lawmakers agreed yesterday on a tax rebate to stimulate consumer spending, a new threat to the economy is emerging because of the complex way the financial system has recently tried to cover its losses. The issue has come to a head as damage mounts from the subprime mortgage/ARM crisis. While early estimates put losses from those troublesome home loans at $250 billion, the total exposure could be five times greater, mortgage analysts and researchers say.

The explanation for that may seem, initially, unrelated to mortgages. Financiers have realized in recent years they could start gambling on things they didn't own. Many banks, hedge funds and institutions began making side bets on a host of other financial developments as varied as an earnings report at Sprint Nextel and the fate of North Korea's economy. Like two gamblers betting on a football game they don't play in, investors all over the world made bets on the performance of securities backed by subprime mortgages [[and other 'events' equally or even more risky : normxxx]]. These bets were so profitable and generated such large fees on Wall Street that they eventually outgrew the total value of the underlying assets themselves.

The market for all of the side bets, called credit default swaps, exploded from $6.4 trillion in 2004 to at least $43 trillion at the end of 2007, far surpassing the total value of the debt markets, according to the Bank for International Settlements. Swaps originated as insurance for financial institutions that lent money. They sold these policies to other investors who, in turn, could trade them and speculate on whether the riskiness of a loan would rise or fall. See "Trader Made Billions on Subprime"

The astonishingly rapid evolution of swaps took place largely outside the view of regulators. [[who, like umpires, are not noted for the acuity of their vision: normxxx]]. Many Wall Street investors now say that these side bets may have magnified losses in the mortgage industry because they pulled in unrelated investors and financial institutions. An example of this danger came to light when a little-known firm called ACA Financial Guaranty caused some of Wall Street's biggest banks to write down billions of dollars in holdings, restating their value on corporate balance sheets. ACA revealed last month that it had promised to cover $60 billion worth of mortgage and corporate debt, but had enough cash to cover only a fraction of that. Merrill Lynch, Citigroup and financial institutions in Canada and France, which had all sold swaps to ACA, had to 'set aside' billions in case the firm collapsed.

ACA isn't the only firm that took on more swaps than it could handle. Two of its larger competitors, MBIA and Ambac Financial Group, had also promised to cover massive losses in subprime mortgages but now say they don't have enough cash to do so. That shortfall is threatening MBIA and Ambac's $1 trillion business of providing insurance to companies and municipalities that issue bonds. The prospect of losses rippling across the bond markets has pushed banks and regulators in New York and Washington to craft a multibillion-dollar rescue package for the firms. It could involve a cash infusion of up to $15 billion. But see "A Messy Squabble Erupts As Bear Stearns Buys Mortgages" for what happens to those guys who bet right and are likely to sue over any such "market manipulation!"

With the possibility of a recession and the global financial system 'unsettled'[!?!] [[to say the least: normxxx]], federal officials say the swaps market has become a primary concern. Since swaps are traded privately, outside any exchange or clearinghouse, it is difficult for regulators to know how quickly and how far losses can spread and who is making the riskiest bets. "Given the size of the market now and the lack of public information on who holds what ... this market will be really tested for the first time if we do see a big round of defaults," said David Munves, head of capital markets research group at Moody's. "It's a risk factor no doubt."

As ACA demonstrated, when one firm in the chain of swaps contracts has a shortfall, it can affect many financial firms and banks around the world, said Greg Medcraft, chairman of the American Securitization Forum, an association of investors. "There is a chain effect," he said [[a chain of unknown length and reach: normxxx]]. "That's the great concern at the moment. It gets to the common theme of trust and confidence. Banks rely on trust and confidence, and if that trust and confidence is impaired, if people start getting panicky about financial credit quality of a counter-party, you'll have a further tightening of credit availability."

[ Normxxx Here:  Which is what happened last summer, when everything financial froze. Think of LTCM, multiplied by a thousand— nobody is responsible for monitoring the "credit-worthiness" of the parties, if they are "well known"— like LTCM"  ]

Since becoming a major financial player, the swaps market has not been tested when default rates were high. In the past few years, as swaps grew, the default rate has remained at historic lows— below 1 percent of all corporations. But both Moody's Investor Services and Standard & Poor's estimate that defaults will reach 4 to 5 percent this year. S&P reported yesterday that the amount of corporate debt issued by companies in distress has increased to its highest level in four years. Bill Gross, managing director of PIMCO, one of the largest bond funds in the world, calculates that losses on swaps contracts could reach $250 billion this year if default rates return to historic norms [[if all goes well, and nobody makes a mistake, and ...: normxxx]]. If a recession were to occur, [[kiss goodbye to the world financial system: normxxx]] the default rate and the resulting losses among swaps likely would be much higher and far more widely felt. Swaps have made the global financial system a much smaller place since they became common in the 1990s.

Corporate bond holders enter into swaps contracts to try to minimize their losses in case the company issuing the bond runs out of cash or cannot make payments on its loans. The bond holder does this by paying a financial firm to cover any losses. That financial firm, in turn, typically creates and sells swaps to cover its own risky positions. This process continues, forming a chain of swap contracts and linking the fortunes of banks, hedge funds and financial firms around the world. As a result, many parties end up sharing the risk of a single investment. Advocates of this financial instrument often say swaps spread risk a mile wide and an inch deep [[it's turned out to be much, much deeper than an inch! : normxxx]].

Over the past few years, bond holders discovered that swaps contracts, when traded, act like corporate bonds, only better. Bond holders are limited in how much they can invest by the total amount of available debt, while swaps traders can create an unlimited number of bets on the same underlying instrument. Two 'counter' parties are needed for a swap to work— one who believes a firm's fortunes are going down and another who believes they are not going down. To bring the parties together, some of Wall Street's biggest banks served as brokers, usually charging 0.1 percent for a $10 million swap contract [[coffee money: normxxx]].

Derek Smith, head of U.S. flow credit trading at Deutsche Bank, said his firm was brokering 100 swap trades a day five years ago. Now it does 1,000. The whole industry does about $50 billion daily, he said. "It's definitely a mainstream instrument now," Smith said. Kent Wosepka, managing director at Standish, which manages $210 billion in investments, says swaps have become bigger and more important to most financiers than the bond markets that created them. "The bond markets are no longer the dog," he said. "They have become the tail. Credit default swaps are the dog now."

But swaps come with a major hazard: You have to know whether the counter-party who has agreed to your contract has the money to cover the loss in the event of a default. Some noted investors such as Warren Buffett have called them "ticking time bombs" and "WMDs: weapons of mass destruction." In a letter published in Investment Outlook, Gross, the PIMCO managing director, warned that the swaps market represents a "bank of shadows" largely because it operates without anyone watching. "Credit default swaps are perhaps the most egregious offenders" of all derivatives, Gross wrote. "Throw in an embarrassed regulatory network consisting of the Fed and Congressional watchdogs asleep at their post, and you have a recipe for credit contraction— a run on the shadow banking system" [[that could dwarf anything that happened in 1929: normxxx]].



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