Global Derivatives Watch: Netting, Collateral and Capital Cushions Matter

In an attempt to demystify the derivatives markets, which have endured an abundancy of malign from both somewhat credible and uninformed critics, I have started to maintain a "Global Derivatives Watch" page HERE, with the intent of providing historical trends of these complex markets along with data analysis at regular intervals. Not only do I trade these markets (namely the options, futures and forex markets), but I see enormous value in derivatives to (a) hedge risks with a defined loss and (b) place bets with a defined loss, when structured properly and controlled with defendable margins and prudent capital controls.

The first fallacy that pervaded the derivatives markets, only to lead to the road to ruin for certain participants in these markets, was that there was ever such a construct as "risk free." Let me assure you that there is nothing of the sort. The second fallacy was that due diligence was not necessary on the derivatives counterparties with which a participant executes a trade, particularly of the sort that includes high leverage or risky collateral, and also particularly on custom over-the-counter (OTC) contracts that don't trade through a clearinghouse or on an exchange. Most equity, futures and forex options and forwards trade on exchanges and have benefitted from the transparency and liquidity. Nearly half of all interest rate swaps (IRS), the largest derivatives market by almost an order of magnitude over all the others in terms of gross market exposure, are cleared through a central clearinghouse, where netting and collateral control can be verified. To be sure, there are many specialized, one-off OTC derivatives that will still be executed between parties directly or through a dealer, but that doesn't minimize the importance in netting, monitoring of underlying or backing collateral quality and value, and capital cushions should a trade go south. (The poster child for failure to execute these tenants is AIG, which should have never been bailed out for its incompetence and risk mismanagement.)

As I like to say, derivatives don't bankrupt people, people bankrupt people. (Sound familiar?)

As the chart above shows, the derivatives markets have grown exponentially over the last two decades, signifying the demand for the ability to hedge and define risks. Much of this demand is due to heightened risks in markets that result from uncertainties in macroeconomic factors, such as interest rate risk, foreign exchange rate risk, systemic default/credit risk, and futures curve (commodity price) risk. Though the credit default swaps (CDS) markets have taken the brunt of the criticisms from an array of punditry, and have spawned one too many sensational bestsellers filled with overblown rhetoric, these instruments do serve a purpose in hedging both macro and microeconomic risks, particularly specific to securities, indexes of securities, companies, institutions and governments.

Just so I don't come off as a rep for one of the industry or lobby groups for derivatives, I will provide my own criticisms of the derivatives markets thus: not everything is known about these markets to gauge systemic stability in the event of gross risk shocks (dislocations) that in turn might bring about market liquidity issues (i.e., selling panic) and lead to serious market degradation and inadvertent losses. Of particular interest is the study of interest rate swaps when rates correct markedly higher or experience extreme volatility, as a result of market panic and inviting more market panic. Understanding the vulnerabilities in markets (not just derivatives, but also equity and debt/bond markets) is valuable and the role of market transparency, disclosure and visibility critical to the task.

 

Vintage Greenspan and the Lessons of LTCM

"There are some who would argue that the role of the bank supervisor is to minimize or even eliminate bank failure; but this view is mistaken, in my judgment. The willingness to take risk is essential to the growth of a free market economy...[I]f all savers and their financial intermediaries invested only in risk-free assets, the potential for business growth would never be realized." –Alan Greenspan, November 1994 [1]

In reviewing these words from "the maestro," one gets an insight into the mind of Federal Reserve (Fed) actions from 1994 to 2008, in particular the dichotomies that promoted risk-taking and investment-driven growth, yet allowed for the rise of moral hazard. In driving an environment of increasingly low interest rates through easy monetary policy, Greenspan manipulated market driven risk-reward and ignited a series of rallies and crashes in the bond and stock markets that distorted normal capital market function.

The private hedge fund Long Term Capital Management (LTCM), one of the first major casualties of the 1998 global bond and stock market swoons, had bet a near 100-to-1 leverage on a risky portfolio mix of directional trades, bond arbitrages, swaps and equity volatility shorts [2]. Though LTCM thought it was "diversified" and "hedged" according to its academic models, it was anything but, placing large bets in markets that became distorted by its very presence and dislocated when the selling started; it didn't help that instead of an early divestiture of a portion of its holdings and a decrease in leverage, LTCM doubled down, falling for the Casanova's Martingale, a betting scheme that provides an eventual win as long as there is enough capital to keep doubling the stake.

After a Fed-orchestrated bailout of LTCM by a plethora of Wall Street firms that had lent LTCM money, had been its counterparty or investment partner, a Fed official issued a telling statement that was ignored by the banking establishment, the Fed and regulators as a whole thereafter:

"LTCM appears to have received very generous credit terms even though it took an exceptional degree of risk...Counterparties obtained information from LTCM that indicated that it had securities and derivative positions that were very large relative to its capital. However, few, if any, seem to have really understood LTCM's risk profile, especially its very large positions in certain illiquid markets. Instead, they appear to have made credit decisions primarily on the basis of LTCM's past performance and the reputation of its partners. LTCM's counterparties...required little or no collateral to cover the potential for future increases in exposures from changes in market values...[and] appear to have significantly underestimated those potential future exposures. Their estimates simply did not make adequate allowance for the extreme volatility and illiquidity of financial markets that surfaced in August and September [1998]. Furthermore, they failed to take into account the potential for credit exposures to increase dramatically if LTCM had defaulted and they and other counterparties had attempted to liquidate collateral and replace derivatives contracts in amounts that in some instances would have been very large relative to the liquidity of the markets in which the transactions would have been executed. Because the counterparties did not take these risks into account, they granted LTCM huge trading lines in a variety of products, and LTCM took advantage of those lines to achieve its exceptional degree of leverage." [3]

The December 1998 testimony in [3] goes on to offer numerous recommendations on risk management and prudential oversight, and in particular on OTC derivatives. Yet this working group and its findings were largely ignored, LTCM bailed out, and the easy credit-moral hazard derby in play.

In bailing out LTCM, major Wall Street firms (Goldman, J.P. Morgan, Merrill, Chase, Salomon, Lehman, plus a number of foreign creditors) agreed to a settlement that would provide in excess of some $4B to cover LTCM's losses, in large part to cover counterparty exposure and to prevent further losses among the counterparties that lent LTCM money or invested with LTCM. On the seemingly positive side, it was the Street and not the Fed that would provide the bailout, but this is not entirely true. After LTCM's failure, the Fed embarked on a series of interest rate cuts to ease jittered markets affected by LTCM's failing positions and hit with the contagion fear of LTCM's fate. The Fed was now catering to the idea of staunching what it thought was systemic risk with monetary intervention, and thereby providing a market-wide bailout.

A decade later, Bear Stearns (LTCM's clearing broker) would experience a more massive failure fate from subsisting on repurchase agreements (repos) and additional short-term funding obtained on favorable credit terms from JPM and other lenders to double down on mortgage debt and derivatives. Bear, like LTCM, thought it was diversified and hedged, when it was anything but, and instead of reducing leverage and positions it too doubled down, especially on securitized mortgage debt (CDOs, or collateralized debt obligations) that it thought could recover in value. When Bear could not sell such illiquid CDOs in an increasingly hostile market, and when its capital positions withered along with its credit lines, Bear received a Fed-orchestrated bailout by JPM, except this time taxpayers received exposure via a $30B backstop from the Fed of increasingly toxic mortgage debt instruments.

Within 6 months, AIG would receive a direct $85B bailout (and later over $100B more) from the Fed, for much the same serial infraction of risk taking as LTCM and Bear. AIG would extend CDO insurance (in the form of credit default swaps or CDSs) to Société Générale, Goldman, Merrill, Deutsche Bank, and many other firms that invested long in the CDO market, without anywhere near the proper capital to cover losses from CDO defaults, should they occur (and they did, en masse, in tail risk fashion). Lehman, like Bear, relied on repo lines and the commercial paper markets to fund its Martingales on CDOs and off-balance-sheet entities such as structured investment vehicles (SIVs) that in turn invested in CDOs to get around regulated capital requirements. Though Lehman succumbed to bankruptcy fate instead of a Fed/Street bailout, Citigroup and Merrill would receive large infusions from the Fed and Treasury, with Merrill taken over by Bank of America.

Many financial pundits today blame the November 1999 repeal of the Glass-Steagall (G-S) Act as the cause of exploding risk taking and moral hazard stemming from systemic risk among large financial institutions. I disagree. In parsing the history of LTCM's failure (which occurred well before G-S was repealed) and the Fed's summary monetary policy response, we didn't need a repeal of G-S to set the stage for exploding risk and moral hazard. The Fed provided plenty of fuel in its cheap money policy for firms to borrow short on cheap terms and invest leveraged long in highly risky assets for their carry interest. Regulation and regulators are obviously not the panacea here. Government needs to quit rewarding moral hazard, to allow firms to fail, and to not intervene with monetary policy bailouts to markets. Financial firms will then get the idea that risk taking does indeed require prudential management and oversight. Business investors in the main who are willing to take on the calculated risks that Greenspan called "essential to the growth of a free market, capitalist economy" know, accept and manage such risks, otherwise they are out of business.

[1] "The New Risk Management Tools in Banking," Alan Greenspan, Address to the Garn Institute of Finance, University of Utah, November 20, 1994. Everyone should read this address, which contains some very persuasive arguments. The tragedy is the actual history that followed, negating Greenspan's credibility. 
[2] Two outstanding books that have documented the rise and fall of LTCM are of note: (a) "When Genius Failed," Roger Lowenstein, c.2000; (b) "Inventing Money," Nicolas Dunbar, c.2000. 
[3] Testimony of Patrick M. Parkinson, Associate Director, Division of Research and Statistics of the Federal Reserve Board, Progress report by the President's Working Group on Financial Markets, Before the Committee on Agriculture, Nutrition, and Forestry, U.S. Senate, December 16, 1998.