By Dan D./TheFundamentalView | 3 September 2009
Let's put the pieces together here. Just this past weekend China announced that State Owned Enterprises (SOEs) will be allowed to default on commodity derivative contracts. Think of that. China has given the green light and authorized its institutions to default on commodity derivative contracts.
This story broke over the weekend but has not gotten much mainstream media attention on this side of the pond. (North America). The only inference to it was the talk or "buzz" on the Wall Street floor that another bank was rumored to be close to defaulting. As Art Cashin of UBS Securities indicated earlier, normally when a market sells off on a rumor and the rumor turns out to be false, the market will tend to correct itself. BUT IT DIDN'T.
The Reuters report cited 6 foreign banks that had received letters indicating that the Chinese State Owned Enterprises would be given the green light to default on their derivatives. A look at what a derivative actually is may be useful here. A Derivative is a financial instrument that is derived from some other underlying asset, index, event, value or condition. Rather than trade or exchange the underlying itself, derivative traders enter into an agreement to exchange cash or assets over time based on the underlying. A simple example is a futures contract: an agreement to exchange the underlying asset at a future date.
Commercial and investment banks make up the foundation of the over the counter (OTC) derivatives market. Investors use derivatives to protect against risks, such as sudden changes in price or value of the underlying asset. Others tap derivatives to take on extra risk, in the hope of extra gains.
Well, China owns billions of dollars worth of these products. And it seems that they have finally had enough of having the value of their derivatives radically altered by the unparallelled action of the asset markets over the last year or two. They have woken up to the fact that these derivatives have been bundled together much like junk in a manner that resembles the mortgage backed derivatives that brought down the world markets last year. [[And, moreover, like them they were sold on the notion that these were "no lose" securities.: normxxx]]
Back to Reuters. Some of the State Owned Enterprises that stated their potential intentions to default were Air China, China Eastern, and Cosco. Mainly in part because they took major derivatives hits over the past year but, also, concerns are arising that the derivatives that they were sold by these foreign institutions are [mostly] garbage, underwater, and may never again see the light of day. So why continue to pay out on them?
So the major concern in the financial world is that holders of these losing products may just walk away, not unlike a home owner with a $600,000 mortgage on a home valued at $475,000 deciding to just hand in their keys. However, read on… this may have nothing to do with morgtgage backed products. This time, the concern may be over Oil.
They (Reuters) cited 6 foreign banks. Where the story gets really intriguing is that among the major derivatives providers according to Reuters but also widely known to the industry, are Goldman Sachs, UBS and JP Morgan. Here is the looming problem. These products are worth billions.
One report, that a good friend of mine did, showed that if Goldman Sachs, for example, were to take this one up the rear, they could stand to lose 15 billion dollars. (This number is by no means confirmed.) An important history lesson is needed here. "Potential default" was the concern that sparked and prompted the most recent economic crisis.
These intricately woven products, along with even the more highly speculative CDOs and CDSs based on them, began to fall apart when the bubble, that was largely created and fed by the financial institutions packaging this junk, started to fall apart. Imagine the impact to the financial landscape if China were to say "we are walking away" from those products. I would imagine that China, being the biggest purchaser of US debt, could surely collapse these and related US institutions that were at one point deemed too "big to fail"— if they (China) decide to go ahead with this plan.
This is why I don't take tonight's news that China purchased 50 billion dollars of IMF bonds lightly. In fact, I take it very seriously. This is why I take the buzz on the floor over the past two days very seriously as well as I do the huge spike in Gold today (Thursday).
Most importantly, I do not take lightly the recent 25% correction we have seen in the Chinese Stock Market. Can all these events be interconnected somehow? Is the Chinese stock collapse giving us a hint?
The Reuters story broke on Mon Aug 31, 2009 at 7:42am EDT. I find it quite interesting that the mainstream media did not take this more seriously. Reuters reported that the above noted Chinese companies have already issued letters to the banks. The Reuters article cites 4 clear points.
• State-owned firms may default on commodity hedges— report
• Bankers dismayed, confused by report; seek more details
• Lawyers question legality of the move
• Traders suspect lurking losses may have prompted warning (Adds analysts comments)
Analysts fear that if these three big companies revealed their derivatives losses and subsequent dismay at the action of these products [[and the way that they were marketed: normxxx]], then this might prompt other large international corporations to do the same. Let's take a closer look at the companies that have been mentioned in these news articles out of China. They are Air China, China Eastern and Cosco. If you ask me, this conundrum might have to do with oil. I deduce from this that if there is a problem brewing it has everything to do with their Oil Derivatives business.
Here's a brief overview of what might happen should these companies, and others, default. The banks, namely Goldman Sachs, J.P. Morgan and from other accounts possibly Deutsche Bank will find themselves LONG on oil futures with no customers on the short side of the derivatives. This will most likely lead the banks to sell the excess oil futures without a care for the price. This is no different than what happened when Bear Stearns was forced to sell off its gold futures in March of 2008 which then resulted in a sharp downturn in the price of Gold (and a crash in gold mining stocks).
Reuters stated:
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We have yet to hear their commentary. A Chinese statesperson was quoted as saying "If we were among the banks receiving that letter, we would be very angry". You can bet your bottom dollar. You don't think that the firms listed above (and the Fed) are angry and frightened that if the Chinese State Owned Entities start taking such actions it could bring down some of the biggest remaining names on Wall Street?
Remember Reuters initial story was titled "Beijing's derivative default stance rattles market." Read it thoroughly for more information. Then, read the following story that broke last Saturday to get a clearer perspective before political and corporate spin started to enter the picture. China warns banks on OTC hedge defaults— report.
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On September 1, 2009 Reuters said that the Banks (as guarantors) would be at risk if China followed through.
Yes, legal battles would ensue should this happen and we can also expect to have Chinese (and other) political figures downplay the story in an effort to avert total market panic. Morever, if they can eventually prove that these derivatives or the underlying assets were somehow 'manipulated' in a manner to profit the bank that issued the product, then that may do even more damage than the defaults themselves.
Perhaps the "buzz" on the floor is indeed true. Perhaps we are going to see action that could annihilate one or more of the biggest Wall Street firms ever. [[Or, even more desperate heroics by the Fed!?!: normxxx]]
If there is one thing I have learned of late is that when the Chinese speak, we must listen. Their list of allies is ever growing and they are all fed up with having to just swallow the US garbage that has turned out to be so toxic and dangerous to their own economic well being. I leave you with these thoughts that I alluded to above.
The Chinese market has corrected some 25%. This news broke this past weekend. New York saw a sharp sell-off on Monday. Buzz of a bank default hit the floor. The rumor did not abate and the selling intensified. The selling carried over into Tuesday.
Gold, a classic hedge against troubled times has broken out to the upside, China has purchased 50 billion in IMF bonds and has been questioning the US dollar now for upwards of a year. China was up 5% overnight. Gold continued to climb Thurday morning.
Where there is smoke there is often fire.
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