I'm a Rooster
The Federal Reserve of New York is calling a meeting to "discuss practices in the credit derivative markets." The meeting is to be held on September 15 and several of the world's largest banks/broker dealers have been called to testify.
This is like asking the fox to search the henhouse for missing chicks.
The discussion is likely to center on clearing and counter-party risks, the same line of thinking that has occurred in the past.
This is like building a road and forgetting to put up traffic lights.
Credit derivatives are not new, but the shape and size of them is changing rapidly. Collateralized mortgage obligations are an older type of credit derivative where pools of mortgages are bought up by the likes of JP Morgan (JPM) and "classes" of return strips are sold out to investors. This is now being done with corporate debt as well. There are other types like credit default swaps and options where specific bets are made on credit between parties.
In all cases there are intermediaries that price and disseminate these products, holding in their portfolios counter-party trades as well as offsets to trades passed on to third parties. These intermediaries are the foxes the Fed has "invited" to discuss the risks.
These dealers, JPM being the largest by far (the second largest was Chase Bank until JPM bought them), control over $250 trillion notional in derivatives of all types, credit being the fastest growing (no I did not miss-type trillion). Certainly the financial system has an interest in making sure there are no counter-party and clearing problems out there. But as I said, this misses the point (traffic lights).
The real risk is at what price the foxes are carrying this mammoth amount of derivatives in their portfolios (where are they marking their positions). There are no external audits being performed of any value or expertise. These dealers have only internal guidelines to follow, essentially allowing traders to use extremely wide discretion (unlike hedge funds like mine who at the end of each month go through a detailed process of marking to market their positions with outside verification).
The CEO of a dealer (bank) needs a penny in earnings to meet expectations. This "need" is passed on down the line and eventually gets to where the "money is made." A manager in charge of derivatives goes to a trader, the trader re-marks a position, and poof, the company has a penny in earnings. The sheer size of these books makes a huge difference to the bottom line of these very levered companies. Over time these things can get significantly miss-marked. The foxes cannot be turned into roosters.
The foxes need traffic lights. There needs to be expert independent verification of pricing to ensure a stable system (roosters). I remember ten years ago when a dealer was forced to re-mark to market its equity index option book because it was being bought by another bank. This resulted in a $3 billion write-off that changed the deal price. That was ten years ago and that was only in equity index options. You can imagine the potential impact today.
I have no proof of all this, just intimate knowledge of how things work. The Fed needs to ask the right questions and more importantly, invite a few roosters to first analyze the books of the dealers and then testify as well.
I am a rooster.
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