http://www.prudentbear.com/creditbubblebulletin.asp

In 200806 is at http://forestpolicy.typepad.com/economics/2006/11/derivatives_man.html but commented.

Doug Noland


Derivatives "Insurance":

November 17 - Bloomberg (Hamish Risk): "The global market for derivatives soared to a record $370 trillion in the first half of 2006, boosted by trading in credit-default swaps, the Bank for International Settlements said. The amount of outstanding credit-default swap contracts jumped to $20.3 trillion from $13.9 trillion at the end of last year, the bank said. The securities are financial instruments based on bonds and loans that are used to bet on an increase or decrease in indebtedness... Trading in derivatives overall grew 24 percent in the first six months..."

A question Tuesday from a journalist: "How does the Fed view this growing (derivatives) market and can we continue to grow at the rapid clip without causing systemic risks?"

Federal Reserve Bank of St. Louis President William Poole: "I'm not speaking for the Fed as a whole. My own position is that the derivatives market is a very fine extension of the depth of our financial markets, because it allows firms to lay off risks and to assume risks at a very measured and targeted way. A lot of the derivatives market - although we often talk about it as creating risk - is actually designed to reduce risk. It allows firms to hedge various positions in ways they could not hedge in the conventional markets - the markets without derivatives. And this is a classic development - it actually goes back to the futures markets and commodities in the nineteenth century, where farmers found that they could lay off risks in wheat futures and corn futures and so forth. And it was productive on both sides because people who specialized in taking risks and understanding risk could be on one side of those transactions and others who want to lay off risk can be on the other side."

"So, I'm a big fan of the derivatives markets. I think that they perform a valuable service in our economy, and I would also say that the derivatives markets provide a lot of valuable information to the Federal Reserve, because we are able to make calculations on various odds of things happening as they are determined by active trading in the markets. So we can read information out of the option market, for example, with certain assumptions about the probabilities that investors are putting on various possible outcomes. And so the derivatives markets are an important source of information for us. I think that these markets are by and large inhabited by people who are very professionally competent in using those markets. Obviously there are some amateurs or people who after the fact will learn that they're amateurs in these markets. But by and large these are competitive and very good markets. I applaud the development of these markets. I think it's good for the economy and good for the Fed."

Clearly, Mr. Poole and the Federal Reserve are oblivious to the precarious mania that has unfolded throughout the Credit Derivatives/"arbitrage" arena. This lack of responsible oversight is not surprising considering the Greenspan Fed's role as vocal proponent for the burgeoning derivatives markets. Still, after the 1987 "portfolio insurance" melt-down, the 1994 mortgage derivatives fiasco, 1995 Orange County and Mexico debacles, the SE Asian dominos collapses, Russia, LTCM, NASDAQ, telecom debt, and Argentina - to list a few major derivative-related market dislocations - I find the Fed's current complacency rather astonishing.

It's fair to assume the Fed's sanguine view has been further hardened by the recent placid backdrop greasing interest-rate and currency derivatives markets, as well by the extended period of relative tranquility in the enormous markets that evolved to hedge mortgage and MBS risks. Currency and interest-rate derivatives expanded phenomenally, setting the stage, one would have thought, for major problems. Yet these marketplaces have been tested by a multiyear dollar decline and a 2-years plus interest-rate "tightening" cycle. In light of this apparent resounding success, emboldened proponents such as Dr. Poole today trumpet derivatives' ability to lay off risk to those better at managing it - in the process reducing overall systemic risk.

I warn, however, that the unfolding risks associated with the proliferation of strategies and explosion of Credit derivatives trading have characteristics that contrast materially to recent experience in currency and interest-rate markets. Let me attempt an explanation, first with respect to the currency derivatives marketplace. Importantly, currency markets have benefited incalculably from the foreign central bank liquidity backstop. This has ensured that, despite the ongoing dollar bear market, Derivatives "Insurance" to protect against a dollar decline has remained inexpensive and readily available.

Those writing/selling this "Insurance" have enjoyed the extraordinary luxury of a captive audience demonstrating insatiable dollar demand - buyers willing to take the other side of the dollar ("dynamic hedging") selling (risk transfer) required to hedge/"reinsure" protection written. And, amazingly, the more acute underlying dollar weakness the more willing they are to accumulate ever greater quantities of U.S. securities. In history's greatest market intervention, foreign central bank (chiefly dollar) reserve holdings have since 2001 ballooned from about $2 Trillion to today's $4.7 Trillion. On the back of virtually limitless central bank dollar support, market players - especially speculators writing Derivative protection - have operated both with the confidence that markets would remain highly liquid and without the fear of abrupt marketplace dislocations (that cause bloody havoc for derivatives hedging strategies). The resulting cheap and readily available "Insurance" has created a perception that fear of further dollar weakness is no cause to liquidate U.S. securities or assets. Instead, simply hedge with Derivatives!

The unprecedented foreign central bank market intrusion can be thought of along the lines of an escalation beyond the GSE [Federal government-sponsored enterprises that currently include Fannie Mae (FNMA), Freddie Mac (FHLMC), Ginnie Mae (GNMA), the Federal Home Loan Banks (FHLB) and their successors.] mortgage/MBS market liquidity backstop. Previous to the (liquidity-creating) ballooning of foreign central bank balance sheets, the fledgling leveraged speculating community for years enjoyed the luxury of placing highly leveraged bets with the comfort that aggressive GSE buying would emerge at the first indication of market stress. Derivative players prospered from the perception of powerful marketplace liquidity support, a backdrop that fostered inexpensive and readily available Derivative "Insurance." This cheap protection played a major role in bolstering leveraged speculation. And the speculative Bubble that enveloped mortgage finance ensured limitless cheap mortgage finance that fueled housing inflation and an economic boom (and, to this point, minimal Credit losses). The relative calm in hedging MBS since 1994 is a byproduct of enormous quasi-governmental market intervention.

While there may be some justification for Dr. Poole's and the Fed's view, it is nonetheless a myth that Derivatives reduce risk overall. In fact, it's today quite the contrary. The booming Derivatives markets are part and parcel to the explosion of global leveraged securities speculation. A mania in writing market "Insurance" (interest-rate, currency, equities, Credit, etc.) has grossly distorted both the pricing of risk throughout the system - and the perception of ongoing availability of cheap Derivatives protection. The series of unprecedented interventions in the currency, mortgage, and interest-rate arenas over time nurtured what is now a proliferation of "Credit arbitrage" speculations - derivatives that profoundly increase systemic risk through the expansion of volumes of risky Credits at this late - exuberant - stage of the Credit cycle.

To make matters much worse, the speculators today writing Derivatives "Insurance" have little in the way of actual resources that could be made available in the event that this protection is called upon to mitigate losses. And while I've made similar claims with respect to the sellers of currency and interest-rate Derivatives, hedging these risks has to this point been made effortless by the massive market interventions noted above. It is not, however, at all clear who will step up to take the other side of ballooning Credit "Insurance" trade when a faltering Credit cycle inevitably forces speculators to rush to hedge (i.e. sell the underlying bond) or liquidate their positions.

Fundamentally, Credit losses are not even insurable - "Insurance" denoting the payment of a premium for protection by the writer of loss protection against independent and random risks. Insurance companies employ scores of actuaries - analyzing vast amounts of historical data - to calculate the probabilities and the expected costs of future claims for a variety of insurable risks - including auto collisions, home fires, health services and deaths. The insurers price premiums sufficiently to achieve profits beyond the accumulation of reserves to be available to settle expected future loss claims. The number of auto accidents across the country during a particular period can be estimated with a high degree of accuracy; these accidents are approximately random and independent events; losses are not generally cyclical; and the availability and pricing of insurance does not significantly increase the overall occurrence of losses.

Credit losses, on the other hand, are categorically non-random and non-independent. They are very much an outgrowth of the Credit cycle, with writing protection against future Credit losses a speculative endeavor rather than "Insurance." During the upside, abundant Credit ensures seductively minimal defaults and losses. The profits from "Writing Flood 'Insurance' During the Drought" entice a reflexive boom in Credit speculation, Availability, and excess. The environment, however, is prone to turn on a dime - with faltering liquidity, lender angst, speculator losses and revulsion, and reinforcing Credit Unavailability fomenting a flurry of defaults and ballooning losses. Unquestionably, data from the cycle's upside will misrepresent downside risks, and the longer the cycle's upside the greater the distortions.

The cycle's final "terminal" phase - replete with extraordinary Credit Availability, seemingly endless market liquidity, marketplace euphoria and resultant gross economic maladjustment - creates perilous distortions in the perception and pricing of myriad risks. In short, this backdrop fosters a massive expansion of risky Credits acutely vulnerable to the cycle's approaching downside. And the last thing we needed was a mania to develop with the speculating Crowd writing Credit protection. When participants from this latest Crowded Trade head for the exits, the lack of a liquidity backstop would seemingly ensure problematic market dislocation.

The problem as I see it today - a dangerous situation that goes largely unrecognized - is one of a freakish Credit cycle that has been perpetuated by a series of interventions (Fed, GSEs, and foreign central banks) - significantly extending the "terminal" phase of perilous excess. Over the life of this historic Credit cycle, the size and scope of leveraged speculation has ballooned, while repeated market interventions have precipitated an increasing focus on the Credit arena for speculative profits. In short, the greatest Credit cycle ever has its finale in highly leveraged speculations and myriad Derivative bets on the worthiness of risky Credits, in the process inciting an issuance boom in the most susceptible Credits.

At the same time, I think I understand the complacency. Beyond the "success" of hedging in the currency and interest-rate markets, the Credit wreckage from the telecom debt bust is today only a distant memory. If anything, the market perceives that the Fed learned from the experience that to stem crisis requires early and aggressive rate cuts. And now, a year past the housing peak, speculators, policymakers and others are emboldened from the reality that the system has yet to suffer from much of an increase in losses after a period of gross mortgage Credit excesses. Why, then, be wary of a bout of profligacy in corporate finance?

Again, it is important to contrast the risk characteristics of the current Derivatives "Insurance" Bubble. The U.S. mortgage finance marketplace is a strange animal, much of it having been effectively nationalized through massive GSE asset and guarantee expansion. Despite the housing downturn, mortgage Credit today remains abundantly available at the easiest terms. Despite the sliver of "equity" backing $Trillions of mortgage guarantees, the markets don't today fear a GSE failure. So, despite apparent housing risks, the marketplace continues to perceive that there is little Credit risk in the vast majority of mortgage securities. Overall, there is minimal fear in throughout the entire Credit system that a surge in Credit losses could lead to restricted mortgage lending. If nothing else, the Fed would aggressively cut rates at the first sign of faltering mortgage liquidity.

It is also worth noting some peculiarities of the corporate debt downturn from earlier in the decade. For one, the greatest excesses were isolated in the telecom/technology industry. When the boom turned to painful bust, much of the economic impact was contained within an important but relatively limited sector of the economy. This generally created a backdrop that gave the Fed much greater flexibility than I expect they will face when the current corporate lending boom falters. Back in 2001, the incipient Mortgage Finance Bubble was not yet promoting destabilizing excess, but was instead poised to become the key post-tech Bubble reflationary mechanism. Outside of technology, inflationary biases had yet to become problematic. Globally, "disinflationary" forces were at their apex. King Dollar was at its zenith, with most global Credit systems disciplined and restrained. Crude oil ended the year near $20. At about $390 billion, 2001's Current Account Deficits was less than half of what our economy will generate this year. The Fed, back in 2001, enjoyed the capacity to aggressively cut rates - eventually to an unprecedented 1% - and leave them at this level for a "considerable time" without inciting conspicuous or market-disturbing inflationary impulses.

Today, the unfolding Derivatives "Insurance" Bubble is creating one additional troubling facet to what has developed into a full-fledged global Credit Bubble comprising U.S. household, government and corporate finance, along with Credit systems and asset markets around the world. Global imbalances and associated liquidity excess are unprecedented, and the dollar vulnerable. Despite the recent energy price decline, the domestic and global backdrop remains inflationary as opposed to dis-inflationary. Here at home, productivity is waning and wage pressures are rising.

Surely, the Fed today lacks the flexibility it enjoyed in 2001. Housing Bubble vulnerability is keeping it from actually tightening financial conditions, leaving "terminal phase" Credit excesses to run unchecked. At the same time, one would assume that speculative excess will hold easing impulses at bay. I am left with the uncomfortable feeling that - with U.S. mortgage, govt., corporate and global Credit Bubbles now largely synchronized - the long-overdue initiation of the Credit cycle's downside will be systemic in nature and likely triggered by some market development.

Thinking back to Dr. Poole's comment that "derivatives markets are an important source of information," I believe that highly speculative Derivatives markets at key junctures provide especially misleading pricing signals. These days, for example, a squeeze on those on the wrong side of the global collapse in Credit spreads is only exacerbating the mis-pricing of Derivatives "Insurance" and risk generally. At the same time, an unwind of speculations is distorting the energy and commodities markets. Meanwhile, a short squeeze is inflating the stock market value of scores of companies - many with questionable fundamentals - in the process encouraging a misallocation of resources reminiscent of the 1990s (but much more broad based). And the Treasury market gyrates daily on rumors of hedge fund liquidations and problems, while currency traders bet on the prospect of the dollar bears getting squeezed.

I know of no other period marked by such pervasive market pricing distortions. As I've argued all along, unlimited Credit/"finance" and unchecked leveraged speculation are the bane of free market Capitalism. Yet it's amazing how recent Monetary Disorder (inflating stock markets) has the "free market" bullish crowd filling the airwaves with flawed analysis and wishful thinking.