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Minyan Mailbag: Derivative Debt


As liquidity, generated almost exclusively by increasing credit, dries up we will hear more and more cries for government to solve the problems they helped create.


Mr. Practical,

Is it possible that the discount rate cut is not the compelling issue in Friday's change? Could it be that parts two and three of the Fed move are the meat of the issue?

1. The nature of the collateral, "home mortgages and related assets" -- that's a whole lot of room to take very questionable collateral off the books of Wall Street and onto the books of the Fed.

2. The "30 day renewable by the borrower" time frame allows those with lousy assets to indefinitely move "related assets" out of their portfolio until the prices improve.

Why isn't there more disclosure? A listing of the institutions using the window. A listing of the paper used as collateral. How does the Fed place a haircut on assets that in some cases have prices that are difficult to discern?

Just one man's humble opinion, but a straight cut in the fed funds rate (which makes yen/carry interesting, unless we get the BOJ to cooperate) would have been a more transparent, less singularly beneficial solution (helping the institutions with bad paper). Is this too conspiracy minded or is it true that sometimes "members only" relief is business as usual?

Thanks for all the great content,
Minyan Chris


Any hope that the Fed would do the right thing has been dashed in my mind.

There seems to be a collective sigh of relief resonating on Wall Street, with some supposedly very intelligent market observers complimenting the Fed on "averting disaster in the financial markets" just as some large financial institutions were warning of potential bankruptcy for want of liquidity. Before those who praise the Fed for prompt action take another breath, I would like to ask them a question: how did things get so bad so quickly when they were saying not two weeks ago that there was no problem at all and how can a simple rate cut correct the problem?

Perhaps the problem is just too simple for them to see. Too much debt was allowed to accumulate. It is that simple. The word "allowed" implies government policies that have encouraged speculation in risky debt that have suppressed market forces that normally would tighten credit before the tipping point.

We all know that traditional measures of debt are at all-time high levels (that is a generalization; for example, traditional measures of corporate debt are around average if off-balance sheet shenanigans are not included). Total global credit markets grew to $98 trln from $75 trln from 2005 to 2006, an incredible 30% increase. The U.S. is a little more than 50% of that.

No wonder we had a global economic "boom" (not really, but the bulls like to call it that)…the world borrowed and borrowed and bought and bought.

But there are more places to look for debt in today's world. What about hidden leverage in the system? Leverage needs to be measured in untraditional ways now due to financial engineers who have reshuffled the debt deck to hide the jokers. The global "derivatives" market is now notional somewhere north of $400 trln, the result of exponential growth over the last ten years, especially the last five.

I don't know anyone who can get a handle on that for sure, but I called my friend John to talk about derivatives.

Let me try to put into English what he told me. First, a derivative contract is simply a bet (usually on the price movement of some underlying asset) where the two opposing parties decide to put relatively a lot of money on its outcome and take each others' credit. In the past, those bets were controlled and put on by buying and selling cash securities that required cash up front. Today all you have to do is find a counter-party to be willing to "make the opposite bet" and take your word that you will pay off. Of course your friendly counter-party can hedge that bet to nullify price exposure, but the real point is that both counter-parties are extending uncontrolled credit at extremely good terms to one another.

At the notional levels we are talking about, tenfold the notional value of cash markets, there is no such thing as benign derivatives. Interest rate swaps, the most benign of all derivatives because of past low volatility, are huge. Counter-party A enters a swap with counter-party B to hedge a rise in fixed rates. Now that A is hedged it allows them to take on more of some risk. B sells futures to hedge their price exposure. Fine. But the problem is both A and B only require only a small amount of collateral posted to do this trade. If the volatility in interest rates picks up and B defaults to A, A is not hedged and the risk they took because they thought they were hedged must be unwound. This multiplies to other counter-parties.

The basic problem is that A was allowed to hedge at too low a cost (giving A the ability to go out and take another risk) and both parties did not require enough collateral to guard against a large move. Really anyone in this chain can cause the first disruption, any weak link like a hedge fund speculating can set off a chain reaction merely because of the leverage (not enough real capital backing risk taking) in the system.

Government policy, including egregious money market operations for years by the Fed, never allowed the market to stop the increasing leverage and debt at a level sustainable relative to realistic volatility and inherent income levels generated by the economy (all the while exporting our income base to Asia). As liquidity, generated almost exclusively by increasing credit, dries up we will hear more and more cries for government to solve the problems they helped create. As we speak I hear that Senator Dodd is meeting with Bernanke and Paulson to "come up with solutions".

I really hope they don't find any, for their solutions will at best delay the inevitable and quite possibly make it worse. The real solution, which will be ignored, is to just let the market sort things out.

-Mr. Practical

No positions in stocks mentioned.
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