Trying to get beyond today’s headlines, and the moves and countermoves in today’s markets, is difficult. However the future beckons, and it’s looking a lot more “deflationary” than “inflationary” which is the exact reason the Fed is throwing around the power of the “lender of last resort.” Don’t want a Depression, do we?
The great de-leveraging of 2008 continues, in which credit market expansion reverses due to excessive credit extended to a myriad of parties who now have trouble paying. One aspect that is now rising to prominence in the banking and non-banking financial world are financial derivatives and counterparty risks borne between parties like banks, hedge funds, brokers, and securities dealers.
In 1996 the US banking system hardly knew derivative financial instruments, but these have proliferated through the following decade to the present day. Think of “vanilla extract” or condensed essence of the vanilla bean. Vanilla extract is the kitchen equivalent of financial debt derivatives to their underlying financial products such as mortgage debt, automobile debt, credit card debt, corporate bonds, interest rate contracts, foreign exchange contracts, over the counter or listed contracts of various kinds. Most derivatives are not traded in public markets but sold in private deals, which makes them hard to track and to evaluate.
Notional values are not actual cash values. The premise of derivatives transactions is that a small amount of real cash can be used to gain exposure to a large amount of notional dollars. Hence the leverage. The movement in the notional values ultimately determines the profit or loss of the underlying derivative contract. Therefore the cash risk exposure of the banks listed below indicate RELATIVE rather than absolute cash exposure.
Trillion $ of notional derivative exposure
JP Morgan $91.7
Bear Stearns $13.4
Morgan Stanley $7.1
Bank Of NY $1.0
In the US banking system, exposure to financial derivatives proliferated but was then reduced by “laying off” or sharing risk with counter parties. It is called “bilateral netting.” The rough amount of derivatives laid off to counterparties rose from 45% of derivatives in 1996 to 85% in 2007. Thus counter party risk is the issue in the mysterious world of derivatives. How solid are your counterparties?
Bilateral netting is essentially the degree or magnitude of financial risk exposure laid off to counter parties. Counter parties such as other banks, perhaps a hedge fund or three, an insurance company, and even a broker such as Bear Stearns. Wait a minute, Bear Stearns? One and the same.
The financial derivatives world is held together by three critical assumptions:
1. Always available liquidity (meaning plenty of cash in the hands of buyers),
2. 100% solvency of counter parties (meaning capacity to pay debts), and
3. A continuous market (no freezes, breaks, or discontinuities please)
Oops. All three of these assumptions have been violated recently in one degree or another, and the Federal Reserve Bank has stepped in.
Up until now we have seen many a “temporary” liquidity or asset swap action on the part of the Fed. Next up in this ongoing chain of events should indeed be some type of Fed sponsored monetization (the true printing of money, so to speak, which really has not yet occurred in its most pure form and in magnitude). As of today, the money printing sequence has not yet blossomed in full form as apparently the Fed is scared of nearer term dollar and global commodity price consequences. That may be changing if “runs” on financial institutions continue, as they must in order for the great Credit Cycle to turn towards less leverage.
Consequences ahead? Maybe a bailout fund, or using Fannie and Freddie as bailout funds, or the Fed simply buying crappy financial derivatives and “products.” Replacing them with cash to insolvent institutions, something well beyond merely increasing liquidity (cash) in the system. It’s what markets really want, Big Daddy to come in and take away their cares, and tell them their sins of greed and extravagance will be lifted away.
I really don’t know what that means for stocks, the US dollar, for prices of anything we buy, or anything we sell. But I’m sure that it will become clear if the Fed takes the next step, which is a doozy.
(There are plenty of experts who read this Blog and they should correct me as needed. But people need to look ahead, not in the rearview mirror.)
This one by Old Vet.