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FW: Bear Stearns is just the beginning

How a meltdown in the $50 trillion credit derivatives market could take down the global financial system

March 24, 2008

John KaschtIt is clearer now than it was a year ago that losses in housing debt will not be isolated. They will lead to losses in credit cards, leveraged corporate loans, automobile loans and most areas of the credit economy. Even emerging market debt, at first sight insulated from the problem, is in practice endangered by its concentration in Latin America and Russia, both dependent either on the U.S. economy itself or on the high oil prices to which U.S. easy money policies have led. Finally, credit default swaps, with an outstanding volume of an extraordinary $50 trillion, appear to be an accident waiting to happen. Thus a mere $1.5 trillion in housing debt losses may indeed produce total losses of $3 trillion or more when collateral damage is included, as New York University professor Nouriel Roubini predicted at an American Enterprise Institute conference the week before last.

Not all of those losses will be felt by financial institutions, although the extraordinary appetite for risk that such institutions have exhibited over the past decade suggests that a high proportion of them may indeed come to rest in the financial area. If that is the case, we have a problem: The total capitalization of the U.S. banking and brokerage system is only about $1 trillion.

The Bear Stearns intervention on March 14 was a first symptom of what we can expect. Notwithstanding its reputation for sharp elbows, Bear was a major house with an important market position. And because its concentration in the mortgage business was greater than several of its competitors, the tsunami now approaching the world's financial system may simply have reached Bear first.

If Mr. Roubini is anything close to right as to the total size of the disaster, and if it spreads, as appears likely, to areas beyond mortgages, then there is no reason to believe that any of the world's major financial institutions are exempt, although in practice some of them will have been exceptionally conservative in their adoption of new financial techniques or will have concentrated their business in areas, such as emerging markets, that are relatively less affected.

As the mortgage blowup has shown, many of the “modern finance” techniques that have been designed in the last 30 years have proven to be fatally flawed. Of all such innovations, probably the one posing the most current danger for the world's financial system is the credit derivatives market.

Like most modern finance products, credit derivatives were marketed as hedges. A bank could reduce its credit exposure to a particular borrower by entering into a contract whereby another bank would make payments to it if the borrower fell into bankruptcy.

Needless to say, once Wall Street's trading desks got hold of credit derivatives, all thought of hedging was lost. Instead of selling a credit exposure once, banks sold it 10 times, or even 20. Instead of selling credit exposure to another bank or an insurance company, which would be able to handle the credit exposure and could be relied upon to pay up in case of trouble, traders sold credit derivatives to hedge funds, private equity funds and any riffraff that walked in off the street.

As a result, the credit derivatives market is a ticking time bomb. It will remain quiescent while credit losses on the underlying loans are low or moderate, but at some point rising credit losses on the underlying loans will be multiplied by the credit default swap mechanism to produce a payment requirement that is several times the size of the underlying defaulted loans. Theoretically, that mega-payment requirement would be offset by mega-profits in other corners of the web of counterparties. In practice, the losses are likely to be large enough to cause counterparties to default, particularly if they are “men of straw,” such as hedge funds, so the profits will prove ephemeral while the losses prove all too real. Losses of even a modest fraction of the $50 trillion principal amount would bring down most of the banking system.

It is in this context that the Bear Stearns crisis must be viewed. When the Knickerbocker Trust went bankrupt in 1907, J.P. Morgan was able to bail out the banking system because the Knickerbocker had limited relationships with other banks. Even when Drexel Burnham went bankrupt, the authorities were able to solve the problem by allowing a two-stage process, whereby Michael Milken and other top management were removed in March 1989, while the institution continued to do business on a sharply reduced basis until its final bankruptcy in February 1990. This was hard on Drexel's shareholders, who might well have salvaged something substantial from the wreckage if Drexel had been forced into Chapter 11 early enough, but it was good for Drexel's network of counterparties, who were given time to get out.

As the above discussion has shown, the network of counterparties for a major house such as Bear Stearns is now many times the size and complexity of that constructed by Drexel and poses huge systemic risk. Bear Stearns may not be too large to fail, and it has no depositors requiring insurance of their money, but its network of interlocking obligations is far too complex and extensive to allow it to cease payments. That explains its takeover by J.P. Morgan Chase, one of Bear's major counterparties.

The Fed is doing everything it can to stave off disaster, but frankly, it is not rich enough. With assets of about $800 billion, having instituted $400 billion of rescue programs in the last two weeks, a $30 billion loan backing J.P. Morgan's takeover of Bear Stearns and a commitment to offer “unlimited” credit to other broker-dealers for the next six months, it is pretty nearly tapped out. It does of course have available a further source of liquidity, the federal printing press. With inflation already moving at a brisk trot, use of that source will replace an incipient recession with a deeper and highly inflationary one.


Martin Hutchinson writes the Bear's Lair column at PrudentBear.com, where this article first appeared.

http://www.financialweek.com/apps/pbcs.dll/article?AID=/20080324/REG/370813373/1023/OTHERVIEWS