Credit Derivatives Deleveraging End Game

By: Mick_Phoenix

Welcome to the Weekly Report. This week we get so bearish that even I worry that my personal sentiment indicator may have reached an extreme. We tie up some loose ends and recap Citigroup.

"The opera ain't over until the fat lady sings." Singing? I doubt there is a bear in the world that isn't humming the Ride of the Valkyries as the charts tell a tale that will scare your grandchildren. It's looking ugly and has the potential to get downright repulsive. That potential shows up when a longer term view of the charts is taken. This week we look at banks, more specifically those banks that participated or later merged/bought/bailed out with banks that helped liquefy the LTCM rescue.

To counter-balance my bearish tendencies, I want to look for potential support areas for banks, places where the current collapse in share prices might come to a halt.

Before we start I want to flag up a couple of previous articles, one by me and another by Adrian Burridge . Both articles were written back in January / February and refer to Citi and the mess it is in, you might find them a handy precursor.

As I mentioned, its time to tie up some loose ends and see if we can identify some possible support for banks. Like Adrian, I see much of the problems today connected to the LTCM debacle, the method used to bail it out and the forgetfulness of bank management. This from Wikipedia (hey, if we use Fed/Govt stats, why not Wiki?):

• "Goldman Sachs, AIG and Berkshire Hathaway offered then to buy out the fund's partners for $250 million, to inject $3.75 billion and to operate LTCM within Goldman Sachs's own trading. The offer was rejected and the same day the Federal Reserve Bank of New York organized a bail out of $3.625 billion by the major creditors to avoid a wider collapse in the financial markets. The contributions from the various institutions were as follows:

  $300 million: Bankers Trust, Barclays, Chase, Credit Suisse First Boston, Deutsche Bank, Goldman Sachs, Merrill Lynch, J.P.Morgan, Morgan Stanley, Salomon Smith Barney, UBS

  $125 million: Société Générale

  $100 million: Lehman Brothers, Paribas

  Bear Stearns declined to participate.

  In return, the participating banks got a 90% share in the fund and a promise that a supervisory board would be established.

  The fear was that there would be a chain reaction as the company liquidated its securities to cover its debt, leading to a drop in prices, which would force other companies to liquidate their own debt creating a vicious cycle.

  The total losses were found to be $4.6 billion. The losses in the major investment categories were (ordered by magnitude):

  $1.6 bn in swaps

  $1.3 bn in equity volatility

  $430 mn in Russian and other emerging markets

  $371 mn in directional trades in developed countries

  $215 mn in yield curve arbitrage

  $203 mn in S&P 500 stocks

  $100 mn in junk bond arbitrage

  no substantial losses in merger arbitrage"

Small sums when compared to what the banks have been writing down of late but these amounts were on top of what the banks position losses in LTCM were. There was a self interest to be served in the LTCM bail-out, banks were able to cover their liabilities, not dissimilar to some theories behind the Bear Stearns and Countrywide buy outs.

Banks ended up with positions that needed to be worked on as well as building capital to cover the bail-out costs. Unfortunately, the good times hadn't finished rolling on and banks began to merge and buy each other, accompanied with large scale management changes and the need to sort out the LTCM legacy was downgraded or forgotten about. It was a time to maximise profits as the dot.com bubble reached toward its zenith, greed took the place of probity. With 10 years to sort out the problem, most management in 1999-2001 probably thought the problem would be for someone else to sort out.

Why 10 years? Here is a snippet from Adrian's article, Long Term Capital and Citigroup:

• "LTCM had over $1 trillion in notionals according to published reports. 10 years ago was 1997. They were active in 10 year swaps. Very active. Swaps don't get unwound. They go to maturity and the losses are reported at maturity."

Oh dear, it looks to me that the problem was not only put off till later but eventually forgotten, except by one or two individuals and quite possibly one bank. So, $1Tn in 10year swaps matured, along with any counter-party positions taken against them in 2007. As Adrian remarks in his article, no wonder LIBOR moved the way it did and credit markets imploded.

So if we use LTCM as a baseline, the beginning of the massive expansion in the credit derivatives market as recognised by The Bank of International Settlements in its 2007 triennial Survey:

• "Growth accelerated in all risk categories. The highest rate of increase was reported in the credit segment of the OTC derivatives market, where positions expanded to $51 trillion, from under $5 trillion in the 2004 survey."

Yep in 3 years credit derivatives went up 10 fold, all of it is invented, electronic, unbacked fiat currency liabilities. If you want to scare yourself on a dark, windy night as the wolf howls outside the door, read this and cower. It's the song sheet that the fat lady grips tightly to her heaving bosom as she reaches a crescendo. LTCM may well be the first "ripple though" event faced by credit derivative markets and probably the smallest.

The BIS reports have changed over the years as some markets became less important and others grew. Here is a quote from the BIS OTC Derivatives Market at the end of June 1998:

• "Allowing for netting lowers the derivatives-related credit exposure of reporting institutions to $1.2 trillion, or to 11% of on-balance-sheet international banking assets."

The figures for 2004-2007 are netted too. So did the expansion begin with the collapse of LTCM? Surprisingly, no - this from the same report, dated end December 1998:

• "Allowing for netting, the increase in the derivatives-related credit exposure of reporting institutions was much smaller, rising by $0.1 trillion to $1.3 trillion (or to 12% of on-balance sheet international banking assets)."

The expansion clearly begins after LTCM, probably as banks decided to inflate the credit derivatives market in an attempt to bury the losses and reduce them to an insignificant amount. No wonder credit itself became so easy to obtain, it was needed to allow the growth of the derivatives, the basic liability and income streams upon which the derivatives are based. Once the explosion of CDO,CDS,MBS,ABS et al (google them if you don't know what they are) occurred and not forgetting that the derivatives themselves have been used as the building blocks for other derivatives, the inevitable bubble, peak and burst were just a matter of time. Unfortunately for the banks, they forgot when that time was.

At the time of LTCM it was interest rate swaps that were the preferred tool with particular concentration in 3 currencies:

• "Much of the expansion in business over the review period can be attributed to the financial turbulence that followed the Russian debt moratorium and the near-collapse of LTCM. This was particularly true in the interest rate segment, where the widespread unwinding of leveraged positions led to an upsurge in interest rate swaps. The increase in interest rate contracts was particularly pronounced in the Deutsche mark (42%), yen (36%) and Swiss franc (25%) segments. While this reflected the ongoing development of derivatives markets outside North America, in the case of the mark it may have been related to the growing benchmark role of German instruments"

Here it gets murky. Were those swaps used as the basis, the collateral, for an increase in reserves to allow the growth of lending which facilitated the expansion of credit derivatives? Did the introduction of Basel 2 cause those swaps to be re-categorised to level 2 or level 3 assets, requiring a rebuilding of reserves and/or a reduction in leverage and lending? Was the maturing of those swaps and the positions built upon them the straw that broke the camels back? Are the actions of Federal Reserve and all the other Central Banks (ECB, Swiss, UK and Japanese "largesse") the returning home of a problem that began in 1998?

It's murky because not only do I not know but I suspect neither do the Central Bankers. What I do know is the concentration of exposure is not as the BIS expected back at the end of 1998:

The development of the Credit Default Swap market moved the risk into a very concentrated "G7" oriented pattern of distribution. The risk in emerging markets has been kept at levels that can be understood and with their relatively small size much easier to regulate and police. Without knowing the counter-parties, the agreed timelines and the triggering events involved in CDS contracts it will become much more difficult to price risk.

Maybe it's better not to know. More worryingly is the continued expansion, especially since H1 07, of the CDS market. Its no coincidence that a massive move to lay off risk accompanied the credit crash and the Bear Stearns implosion (which did not happen in March this year). The table below shows that expansion and the timescale. Elliott wavers (and Gann followers) are going to love this one:

CDS nearly tripled in 6 months. These 5 year on the run instruments will expire in…..2012. Now they may well be traded out before then but I doubt a single EW'r didn't smile on seeing this.

Finally the banks, here is a selection of monthly charts.....To read the rest of the Weekly Report, click here

By Mick Phoenix
www.caletters.com

An Occasional Letter in association with Livecharts.co.uk

To contact Michael or discuss the letters topic E Mail mickp@livecharts.co.uk .

Copyright © 2008 by Mick Phoenix - All rights reserved.

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