Don't wait to the bomb goes off to get in!
Silver rush hour is close!
I have seen the financial ticking time bomb!
Source:The Australian Business with the Wall Street Journal
Andrew Baggio | October 18, 2008
FINANCIAL institutions are at the confessional once again.
They have made unprecedented provisions and write-downs against the toxic debt on their balance sheets.
Our banks have assured us, hands on hearts, that their houses are now in order.
But a further and critical time bomb exists within our financial system. To date it is largely unreported and unknown.
When this bomb explodes, the mushroom cloud will be of a magnitude that dwarfs the current crisis and will change the world forever. This bomb is the over-the-counter derivatives market.
OTC derivatives were developed as a legitimate and sensible hedging mechanism against price movements in currency and interest rate markets. From humble beginnings, these derivative contracts, typically made between two counterparties over the telephone, have developed into the most complex financial and legal relationships in existence.
And the global OTC derivative market is entirely unregulated. These instruments are not listed on any exchange and their prices cannot be seen in any newspaper. They typically do not appear on any external balance sheet.
Should we taxpayers be concerned that governments have agreed to pledge sovereign wealth -- our national inheritance -- to support institutions with black hole exposures that cannot be quantified? Absolutely.
Although almost infinite in variety, a common OTC derivative is that known as a credit default swap (often called a CDS). This product looks and smells like credit insurance but is not regarded as such (to avoid regulation applied to the insurance industry) due to form over substance arguments made (and won) by lawyers.
Let me describe how these beasts are used:
Bruce is a successful, corporate finance executive at Bigbank, an investment bank in New York. Bruce has an MBA, is an alpha male and lives for "the deal".
Steve heads the OTC derivatives team at Bigbank. With a PhD in pure mathematics, Steve focuses on financial models.
Although he earns more than most of them, Bruce is not known to the directors on the board of Bigbank. The corporate finance department is large and Bruce is one of many talents there.
Steve's department, on the other hand, has come to the board's attention recently as it has generated extraordinary returns of late -- without using any bank capital and, based on Steve's extensive modelling and assurances, seemingly without risk.
Although on an enormous salary by most standards, Bruce's real jam is made on a commission basis from deals that he writes.
Bruce has an opportunity to write a huge loan to (or underwrite a huge bond issue by) General Motors. Bruce's credit risk analysts tell him that the loan represents an unacceptable exposure for Bigbank to the car industry -- or perhaps the US economy -- or whatever. This is prudent banking practice. But Bruce needs this deal because, in anticipation of a large bonus in December, he has contracted to buy a chalet in the French Alps and settlement is looming. So Bruce rings Steve within the derivatives team at Bigbank and asks him to arrange a CDS over GM for the new loan.
After a few telephone calls to other derivatives teams around the world, Steve has identified that an Australian bank, Ozbank, wants more exposure to the car industry and the US economy. Ozbank's market analysts have determined that its portfolio is underweight in those areas.
Under the terms of the CDS, Ozbank will pay Bigbank a margin over the current interbank lending rate every six months and Bigbank will pay Ozbank the interest it receives from GM on the new loan (a little like an insurance premium). Ozbank is delighted because it now has exposure to the US auto industry without having to set aside capital (as it would ordinarily have to do under bank prudential laws) or show the exposure on its balance sheet. (And the rate of interest is outstanding given GM's troubles).
Indeed, the clever people at Ozbank have now packaged a few hundred of these contracts within a special purpose vehicle (or SPV), an Ozbank subsidiary, and sold securities in the SPV to a number of other institutions and superannuation funds that would like a piece of the US automobile market. To shore up the concerns of the super fund trustees, Ozbank has arranged for a large and seemingly untouchable insurance company (known as a "wrapper") to guarantee the obligations of SPV. A ratings agency has been retained and paid a large amount of money by Ozbank to issue an investment grade credit rating on the securities.
Bigbank is able to keep the new loan to GM off its balance sheet (and therefore undisclosed to outsiders) due to the ambiguities of the accounting standards and the skills of its audit and assurance team. A fax is exchanged to confirm the summary terms of the derivative trade and the loan is made to GM.
The lengthy contractual terms between Bigbank and Ozbank, containing important details of their collateral to each other and other protective and mechanical provisions, have not been agreed or settled by back office staff despite negotiation for more than two years. (Bruce is aware of this but if you listened to those handbrakes in compliance you would never do any business!)
The back office of the bank, a cost centre rather than a profit centre, is under-resourced and has about 80 such unresolved and unexecuted derivatives master agreements afoot at any one time. Nor is there much communication between the trading desk and the back office -- after all, the support team are located in India.
Bruce books the deal and calls his land agent in Geneva. It is an excellent result for all concerned.
Importantly, however -- and here is the time bomb -- the CDS provides that if GM defaults on its loan (or any number of other events occurs in relation to GM's creditworthiness), SPV must pay out the loan to Bigbank and take over Bigbank's exposure to GM.
Let us assume GM now defaults on an interest payment. Bigbank is fortunate because it is early days in this crisis and this is Ozbank's first call on a CDS (although Bigbank has other fires to douse because it has purchased CDS exposures from other banks). SPV now finds itself the owner of worthless paper (assuming the terms of the derivatives contract can ever be agreed in litigation because it was never executed) and having to participate as an unsecured creditor in GM's bankruptcy -- an expensive and fruitless exercise.
Unfortunately the "wrapper" is also in financial difficulty and has filed for bankruptcy in the US. The ratings agency is asserting the release and waiver in its engagement conditions -- and, were it to be sued, it has no capital anyway.
Financial engineering is a fascinating subject -- perhaps though, like genetic engineering, it is best left alone. Financial alchemists can slice and dice any form of property, package it, market it and sell it in a form that bears no semblance to its individual parts.
This can be repeated any number of times. In many cases it is not clear whether the ultimate commodity is an asset, a liability or something else. When orthodox assumptions break down, as they have at present, these instruments and the financial exposures inherent in them are impossible to value and quantify -- even by their own engineers.
And our Government in its wisdom has agreed that we will guarantee the obligations of our financial institutions with these hidden time bombs.
Andrew Baggio, principal of Baggio Legal in Adelaide, worked as a senior structured finance lawyer
MMN
macmin silver ltd
