Interest Rate Roundup

Monday, February 18, 2008

More on "financial WMD"

"Financial weapons of mass destruction." That's what Warren Buffett called derivatives back in his 2002 letter to shareholders (see this pdf link, page 15). Those comments certainly seem germane today, especially in light of the almost daily headlines about more turmoil in the credit market. Many forms of complex derivatives are causing big problems in the financial industry. Some contracts can't be valued at all. And the values being put on those that can are causing widespread writedowns and headaches.

If you didn't check out the cheery New York Times story "Arcane Market Is Next to Face Big Credit Test" over the weekend, it may help better explain potential problems in one derivatives market for you. Here's an excerpt:

"Few Americans have heard of credit default swaps, arcane financial instruments invented by Wall Street about a decade ago. But if the economy keeps slowing, credit default swaps, like subprime mortgages, may become a household term.

"Credit default swaps form a large but obscure market that will be put to its first big test as a looming economic downturn strains companies’ finances. Like a homeowner’s policy that insures against a flood or fire, these instruments are intended to cover losses to banks and bondholders when companies fail to pay their debts.

"The market for these securities is enormous. Since 2000, it has ballooned from $900 billion to more than $45.5 trillion — roughly twice the size of the entire United States stock market.

"No one knows how troubled the credit swaps market is, because, like the now-distressed market for subprime mortgage securities, it is unregulated. But because swaps have proliferated so rapidly, experts say that a hiccup in this market could set off a chain reaction of losses at financial institutions, making it even harder for borrowers to get loans that grease economic activity."

Also, be sure you check out the multiple posts I've been putting up on this topic for months, including here and here, as well as this post referencing some comments from Bill Gross at Pimco

Still not concerned about financial WMD? Then sit down, grab a cup of coffee and read about a potential "correlation crisis" over at the FT ...

"The world of synthetic collateralised debt obligations is suffering as the cost of protecting corporate debt against default via credit derivatives – from which these CDOs are created – continues to be pushed higher.

"But there is another problem building, and some fear it could lead to a repeat of the correlation crisis of 2005, which saw hedge funds and investment banks suffer hundreds of millions of dollars worth of losses.

"The problem then was that investment banks and hedge funds had built up large exposures to the riskiest equity tranches of synthetic CDOs, which pay the highest returns but bear the first losses from any defaults in an underlying pool of credit derivatives.

"When sentiment changed suddenly after the shock downgrades of US carmakers GM and Ford, these investors found that there was no market for the risk they held.

"Now a similar correlation pattern has emerged as hedge funds have loaded up on the same risk by selling protection on equity tranches."

On the up side, it is a holiday here in the U.S. (at least for SOME people, grumble, grumble) So if you don't feel like worrying about an alphabet soup of derivatives and structured finance securities, by all means, turn off your computer and go enjoy yourself. I'm sure there will be a new crisis to worry about tomorrow at the rate things are going!


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