Wednesday, May 31, 2006

 

'Derivatives Becoming Pre-Curser To Cash'

Bloomberg looks at the changing world of derivatives. "When Mark Kiesel, who manages $50 billion at Pacific Investment Management Co., decided this month that corporate bonds were about to slump, he bought credit default swaps. Louise Herrle, treasurer of mortgage lender Residential Capital Corp., measures investor demand for debt by looking at credit default swap prices before she decides to sell a bond."

"Such derivatives, contracts that insure investors against defaults, are displacing trading of corporate debt as the surest way to gauge a company's health. The market totals $17 trillion, more than three times the amount of U.S. company bonds."

"'The credit default swap market is now the dog as opposed to the tail that wags the dog,' said John Burger, managing director at Merrill Lynch & Co. The change to credit derivatives happened in the last 18 months, he said."

"The Dow Jones CDX North American Investment Grade Index, which tracks the derivatives on 125 company bonds, rose almost 15 percent in the first two weeks of May. The next week, corporate bonds posted their worst performance in a year. 'We strongly believe that today, the credit derivatives market is fast becoming a precursor to the cash market,' said Jayesh Bhansali, head of derivatives strategy and trading at TIAA-CREF. 'This market is a very sensitive barometer.' TIAA-CREF, the largest U.S. manager of retirement funds for university and college employees, manages $380 billion."

"Derivatives related to corporate debt are the fastest- growing part of the $270 trillion market for financial obligations that are based on the performance of assets such as stocks, currencies and commodities, or on the outcome of events including defaults or changes in weather patterns. The credit derivatives market has grown from almost nothing in eight years. It more than doubled in 2005."

"'Credit default swaps are becoming the most important instrument I've seen in decades,' Former Federal Reserve Chairman Alan Greenspan said May 18 at a Bond Market Association conference in New York. 'For decades we used to have monetary crises because banks' would periodically 'freeze up.' Credit default swaps 'lay off all of these loans.'"

"The Dow Jones investment grade index, which shows the average cost of insuring debt sold by borrowers including AT&T Inc. and Wal-Mart Stores Inc., rose almost 5 points to 39 between May 2 and May 12, Bloomberg data show. A level of 39 means it costs an investor $39,000 to insure $10 million of debt for five years. The extra yield investors demand to own investment-grade corporate bonds rather than Treasuries, or spread, didn't widen until the week ending May 19. Then it rose 3 basis points to an average of 90 basis points."

"Though the credit default market has surged, the derivatives haven't been measured in a period of increasing corporate bankruptcies. 'Given that credit derivatives allow for a leveraging of credit risk, a down cycle in credit will surely result in large investor losses,' Merrill's Burger said."

"When Delphi Corp. filed for bankruptcy on Oct. 8, there were $20 billion of credit default swaps related to its $2 billion of bonds. The imbalance drove up prices of the bonds and forced banks to hold an auction to determine a price to settle the derivatives. It took Moody's Investors Service four months to figure out the impact of the Delphi default on the market for credit default swaps and securities that contain the derivatives."

"Securities firms were unprepared to handle the growth of credit default swaps. The Federal Reserve Bank of New York demanded last September that 14 firms, including Deutsche Bank AG, Goldman Sachs Group Inc. and JPMorgan Chase & Co., improve their handling of credit derivatives after discovering 150,000 unconfirmed or unsigned transactions. Delays in documenting trades meant buyers and sellers may have been unaware of who owed money to whom in the event of a default."

"Investors who want to bet that bond prices and credit quality will decline can use the CDX index more easily than individual bonds. To bet on a drop in the cash market, investors have to borrow bonds and sell them in the hope they can repurchase the securities at a lower cost later. That trade incurs commissions and financing costs."

"With derivatives, they don't have to worry about coming up with the actual bond because dealers and investors can create as many credit default swaps as they want. Trading in credit derivatives doubled in the last two years to $10 billion a day, according to Nishul Saperia, at derivatives data company Markit Group Ltd. By contrast, an average $21.6 billion of company bonds changes hands daily at Wall Street's biggest firms, about the same as two years ago, Fed data show."

Comments:
'The Federal Reserve Bank of New York demanded last September that 14 firms, including Deutsche Bank AG, Goldman Sachs Group Inc. and JPMorgan Chase & Co., improve their handling of credit derivatives after discovering 150,000 unconfirmed or unsigned transactions.'

I posted on this. It was a surprise raid by the Fed. For a market to have grown so much in such a short time, one would think a little more structure would be in place. Paper stacked on paper.
 
Can someone explain this in laymans terms?...Sorry, some of us are not very smart??
 
It means there is a big, unregulated market out there that no one really understands.
 
Supports the notion it's easier to make money when nobody's looking, or, more importantly, actually seeing what you're doing.
 
It means there is a big, unregulated market out there that no one really understands.
# posted by gofast777 : 12:57 PM

As funny as it may sound, that responce is 100% correct. You can not get a truly clear answer on how the derivatives game works, all you get are 360 degree answers about forward betting. I've asked before.
 
"Former Federal Reserve Chairman Alan Greenspan said May 18 at a Bond Market Association conference in New York. 'For decades we used to have monetary crises because banks' would periodically 'freeze up.' Credit default swaps 'lay off all of these loans.'"

Sure Alan. But... lay off 'where'?

The notion that hedge fund purchases of packaged risk, somehow reduce risk to the banking system is a questionable one. Not only do hedge funds just transfer the risk to different players -- but they probably *add* risk to overall economic stability since the degree of fund leverage is never known.

The banking system as a whole is operating hand-in-hand with the hedge fund industry by securitizing and bundling risk as derivatives and then "offloading" that risk. In other words, the "regulated" banking industry profits by passing risk to the "unregulated" banking industry.

That's a recipe for disaster.

The Banks' justification is that the investor pool is different (wealthy private equity groups vs. retail investors), but given the fact that there are trillions of dollars in hedge funds, the risk isn't just to investors. The risk is to the economy as a whole. Imagine the 'Long Term Capital Management' fiasco, multiplied by 1000.

The same thing is happening with mortgage-backed securities. Fannie Mae clears its books daily, by securitizing broad based mortgage risk and selling it to hedgies and private-client groups (both groups escape regulation through 'accredited investor' status).

So, Fannie Mae gets to show clean non-risk books to the government. ..But ultimately should that debt unwind, the economic impact could be tremendous.
 
Stress testing the derivatives market should make for interesting times. I'll be in my bunker behind the canned food.
 
I guess I should add to my stash of beanie weenies and van camp pork and beans.
 
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