Best of the Week
Most Popular
1. TESLA! Cathy Wood ARK Funds Bubble BURSTS! - 12th May 21
2.Stock Market Entering Early Summer Correction Trend Forecast - 10th May 21
3.GOLD GDX, HUI Stocks - Will Paradise Turn into a Dystopia? - 11th May 21
4.Crypto Bubble Bursts! Nicehash Suspends Coinbase Withdrawals, Bitcoin, Ethereum Bear Market Begins - 16th May 21
5.Crypto Bubble BURSTS! BTC, ETH, XRP CRASH! NiceHash Seizes Funds on Account Halting ALL Withdrawals! - 19th May 21
6.Cathy Wood Ark Invest Funds Bubble BURSTS! ARKK, ARKG, Tesla Entering Severe Bear Market - 13th May 21
7.Stock Market - Should You Be In Cash Right Now? - 17th May 21
8.Gold to Benefit from Mounting US Debt Pile - 14th May 21
9.Coronavius Covid-19 in Italy in August 2019! - 13th May 21
10.How to Invest in HIGH RISK Tech Stocks for 2021 and Beyond - Part 2 of 2 - 18th May 21
Last 7 days
Overclockers UK Custom Built PC 1 YEAR Use Review Verdict - Does it Still Work? - 16th Oct 21
Altonville Mine Tours Maze at Alton Towers Scarefest 2021 - 16th Oct 21
How to Protect Your Self From a Stock Market CRASH / Bear Market? - 14th Oct 21
The Only way to Crush Inflation (not stocks) - 14th Oct 21
Why "Losses Are the Norm" in the Stock Market - 14th Oct 21
Sub Species Castle Maze at Alton Towers Scarefest 2021 - 14th Oct 21
Which Wallet is Best for Storing NFTs? - 14th Oct 21
Ailing UK Pound Has Global Effects - 14th Oct 21
How to Get 6 Years Life Out of Your Overclocked PC System, Optimum GPU, CPU and MB Performance - 13th Oct 21
The Demand Shock of 2022 - 12th Oct 21
4 Reasons Why NFTs Could Be The Future - 12th Oct 21
Crimex Silver: Murder Most Foul - 12th Oct 21
Bitcoin Rockets In Preparation For Liftoff To $100,000 - 12th Oct 21
INTEL Tech Stock to the MOON! INTC 2000 vs 2021 Market Bubble WARNING - 11th Oct 21
AI Stocks Portfolio Buying and Selling Levels Going Into Market Correction - 11th Oct 21
Stock Market Wall of Worry Meets NFPs - 11th Oct 21
Stock Market Intermediate Correction Continues - 11th Oct 21
China / US Stock Markets Divergence - 10th Oct 21
Can US Save Taiwan From China? Taiwan Strait Naval Battle - PLA vs 7th Fleet War Game Simulation - 10th Oct 21
Gold Price Outlook: The Inflation Chasm Between Europe and the US - 10th Oct 21
US Real Estate ETFs React To Rising Housing Market Mortgage Interest Rates - 10th Oct 21
US China War over Taiwan Simulation 2021, Invasion Forecast - Who Will Win? - 9th Oct 21
When Will the Fed Taper? - 9th Oct 21
Dancing with Ghouls and Ghosts at Alton Towers Scarefest 2021 - 9th Oct 21
Stock Market FOMO Going into Crash Season - 8th Oct 21
Scan Computers - Custom Build PC 6 Months Later, Reliability, Issues, Quality of Tech Support Review - 8th Oct 21
Gold and Silver: Your Financial Main Battle Tanks - 8th Oct 21
How to handle the “Twin Crises” Evergrande and Debt Ceiling Threatening Stocks - 8th Oct 21
Why a Peak in US Home Prices May Be Approaching - 8th Oct 21
Alton Towers Scarefest is BACK! Post Pandemic Frights Begin, What it's Like to Enter Scarefest 2021 - 8th Oct 21
AJ Bell vs II Interactive Investor - Which Platform is Best for Buying US FAANG Stocks UK Investing - 7th Oct 21
Gold: Evergrande Investors' Savior - 7th Oct 21
Here's What Really Sets Interest Rates (Not Central Banks) - 7th Oct 21
CISCO 2020 Dot com Bubble Stock vs 2021 Bubble Tech Stocks Warning Analysis - 6th Oct 21
Precious Metals Complex Searching for a Bottom - 6th Oct 21
FB, AMZN, NFLX, GOOG, AAPL and FANG+ '5 Waves' Speaks Volumes - 6th Oct 21
Budgies Flying Ability 10 Weeks After wings Clipped, Flight Feathers Cut Grow Back - 6th Oct 21
Why Silver Price Could Crash by 20%! - 5th Oct 21
Will China's Crackdown Send Bitcoin's Price Tumbling? - 5th Oct 21
Natural Gas News: Europe Lacks Supply, So It Turns to Asia - 5th Oct 21
Stock Market Correction: One More Spark to Light the Fire? - 5th Oct 21
Fractal Design Meshify S2, Best PC Case Review, Build Quality, Airflow etc. - 5th Oct 21
Chasing Value with Five More Biotech Stocks for the Long-run - 4th Oct 21
Gold’s Century - While stocks dominated headlines, gold quietly performed - 4th Oct 21
NASDAQ Stock Market Head-n-Shoulders Warns Of Market Weakness – Critical Topping Pattern - 4th Oct 21
US Dollar on plan, attended by the Gold/Silver ratio - 4th Oct 21
Aptorum Group - APM - High RIsk Biotech Stocks Buy, Sell, Hold Investing Analysis for the Long-run - 3rd Oct 21
US Close to Hitting the Debt Ceiling: Gold Doesn’t Care - 3rd Oct 21
Powell: Inflation Might Not Be Transitory, After All - 3rd Oct 21
Original Oculus VR HeadSet Rift Dev Kit v1 Before Facebook Bought Oculus - 3rd Oct 21
Microsoft Stock Valuation 2021 vs 2000 Bubble - Buy Sell or Hold Invest Analysis - 1st Oct 21
How to profit off the Acquisition spree in Fintech Stocks - 1st Oct 21
�� Halloween 2021 TESCO Shopping Before the Next Big Panic Buying! �� - 1st Oct 2
The Guide to Building a Design Portfolio Online - 1st Oct 21
BioDelivery Sciences International - BDSI - High RIsk Biotech Stocks Buy, Sell, Hold Investing Analysis for the Long-run - 30th Sep 21
America’s Revolving-Door Politics Behind the Fall of US-Sino Ties - 30th Sep 21
Dovish to Hawkish Fed: Sounds Bearish for Gold - 30th Sep 21
Stock Market Gauntlet to the Fed - 30th Sep 21
Should you include ESG investments in your portfolio? - 30th Sep 21
Takeda - TAK - High RIsk Biotech Stocks Buy, Sell, Hold Investing Analysis for the Long-run - 29th Sep 21
Stock Market Wishing Away Inflation - 29th Sep 21
Why Workers Are NOT Returning to Work as Lockdown's End - Wage Slaves Rebellion - 29th Sep 21
UK Fuel PANIC! Fighting at the Petrol Pumps! As Lemmings Create a New Crisis - 29th Sep 21
Gold Could See Tapering as Soon as November! - 29th Sep 21

Market Oracle FREE Newsletter

How to Protect your Wealth by Investing in AI Tech Stocks

Derivatives Dominos Start Falling Threatening Collapse of the Shadow Banking System

Stock-Markets / Credit Crisis 2008 Mar 17, 2008 - 01:24 AM GMT

By: Mike_Whitney

Stock-Markets

Best Financial Markets Analysis ArticleOn Friday, Bear Stearns blew up. It was the worst possible news at the worst possible time. A day earlier, the politically-connected Carlyle Capital hedge fund defaulted on $16.6 billion of its debt. Carlyle boasted a $21.7 billion portfolio of AAA-rated residential mortgage-backed securities, but was unable to make a margin call of just $400 million. (Where did the $21.7 billion go?) The news on Bear was the last straw. The stock market started reeling immediately; shedding 300 points in less than an hour. Then, miraculously, the tide shifted and the market began to rebound. If there was ever a time for Paulson's Plunge Protection Team to come to the rescue; this was it.


For weeks, the markets have been battered with bad news. Retail sales are down, unemployment is up, consumer confidence is in the tank, inflation is rising, the dollar is on the ropes, and the credit crunch has spread to even the safest corners of the market. Facing fierce headwinds, Washington mandarins and financial heavyweights had to decide whether to sit back and let one small investment bank take down the whole equities market in an afternoon or stealthily buy a few futures and live to fight another day? Tough choice, eh?

We'll never know for sure, but that's probably what happened. 

We'll also never know if Bernanke's real purpose in setting up his new $200 billion auction facility was to provide the cash-strapped banks with a place where they could off-load the mortgage-backed junk that Carlyle dumped on the market when they went belly-up. That worked out well, didn't it? Now the banks can trade these worthless MBS bonds with the Fed for US Treasuries at nearly full value. What a deal! That must have been the plan from the get-go.  

The Bear Stearns bailout has ignited a firestorm of controversy about moral hazard and whether the Fed should be in the business of spreading its largess to profligate investment banks. But the Fed had no choice. This isn't about one bank caving in from its bad bets. The entire financial system is teetering and a failure at Bear would have taken a wrecking ball to the equities market and sent stocks around the world into a violent death-spiral.

The New York Times summed it up like this in Saturday's edition:“If the Fed hadn't acted this morning and Bear did default on its obligations, then that could have triggered a widespread panic and potentially a collapse of the financial system”.

Bingo.

So, what makes Bear so special? How is it that one of the smallest investment banks can pose such a threat to the whole system?

That's the question that will be addressed in the next couple weeks and people are not going to like the answer. For the last decade or so the markets have been reconfigured according to a new “structured finance” model which has transformed the interactions between institutions and investors. The focus has been on maximizing profit by creating a vast galaxy of exotic debt-instruments which increase overall risk and volatility in slumping market conditions.

Derivatives trading which, according to the Bank of International Settlements, now exceeds $500 trillion, has sewn together the various lending and investment institutions in a way that one failure can set the derivatives dominoes in motion and bring down the entire financial scaffolding in a heap. That's why the Fed got involved and (I believe) approached Congress in a closed-door session (which was supposed to be about FISA legislation) to inform lawmakers about the growing possibly of a major economic meltdown if conditions in the credit markets were not stabilized quickly.

The troubles at Bear and the danger they pose to the overall system were articulated in an article by Counterpunch editor, Alexander Cockburn in a November, 2006 article “Lame Duck: The Downside of Capitalism”: “In a briefing paper under the chaste title, 'Private Equity: A discussion of Risk and Regulatory Engagement', the FSA raises the alarm.

"Excessive leverage: The amount of credit that lenders are willing to extend on private equity transactions has risen substantially. This lending may not, in some circumstances, be entirely prudent. Given current leverage levels and recent developments in the economic/credit cycle, the default of a large private equity backed company or a cluster of smaller private equity backed companies seems inevitable. This has negative implications for lenders, purchasers of the debt, orderly markets and conceivably, in extreme circumstances, financial stability and elements of the UK economy."

Translation: It's about to blow!

"The duration and potential impact of any credit event may be exacerbated by operational issues which make it difficult to identify who ultimately owns the economic risk associated with a leveraged buy out and how these owners will react in a crisis. These operational issues arise out of the extensive use of opaque, complex and time consuming risk transfer practices such as assignment and sub-participation, together with the increased use of credit derivatives. These credit derivatives may not be confirmed in a timely manner and the amount traded may substantially exceed the amount of the underlying assets."(snip)

Translation: "The world's credit system is a vast recycling bin of untraceable transactions of wildly inflated value.

The problem is that the oversight and stability of the world credit system is no longer within the purview of familiar international institutions like the International Monetary Fund or the Bank of International Settlements. Private traders are now installed at all the strategic nodes, gambling with stratospheric sums in such speculative pyramids as the credit derivative market which was almost nonexistent in 2001, yet which reached $17.3 trillion by the end of 2005. Warren Buffett, America's most famous investor, has called credit derivatives "financial weapons of mass destruction." ( Alexander Cockburn, “ Lame Duck: The Downside of Capitalism ” )

Cockburn's article anticipates the current problems at Bear and shows why the Fed cannot allow them to fester and spread throughout the system. The investment banks and brokerages all do business with each other, taking sides in trades as counterparties. If one player goes down it increases the likelihood of more failures. So the problem has to be contained.

The volume of derivatives contracts, that are not traded publicly on any of the major exchanges, has exploded in the last few years. These unregulated transactions, what Pimco's Bill Gross calls the shadow banking system, have taken center-stage as market conditions continue to deteriorate and the downward-cycle of deleveraging begins to accelerate. The ongoing massacre in real estate has left the structured investment market frozen, which means that the foundation blocks (ie mortgage-backed securities) upon which all this excessive leveraging rests; is starting to crumble. It's a real mess.

Derivatives trading, particularly in credit default swaps, is oftentimes exceeds the value of the underlying asset many times over. Credit Default Swaps are financial instruments that are based on loans and bonds that speculate on a company's ability to repay debt. (a type of unregulated insurance) The CDS market is roughly $45 trillion, whereas, the aggregate value of the US mortgage market is only $11 trillion; four times smaller. That's a lot of leverage and it can have a snowball effect when the CDSs trades begin to unwind.

In truth, the biggest risk to the financial system is counterparty risk; the possibility that some large investment bank, like Bear, goes under and sucks the rest of the market with it from the magnitude of its losses. Last year, Bear was the 12 th largest counterparty to CDS trades according to Fitch ratings. If they were to suddenly disappear, the effects to the rest of the system would be catastrophic.

Fed Chairman Bernanke sat on the board of the FOMC when the investment gurus and brokerage sharpies customized the markets in a way that enhanced their own personal fortunes while increasing the risks of systemic failure. The SIVs, the conduits, the opaque derivatives, the off-balance sheets operations, the dark pools, the massive leverage, and the reckless expansion of credit; all emerged during his (and Greenspan's) tenure. The Federal Reserve is largely responsible for the brushfire they are presently trying to put out. 

Now, once again, Bernanke is acting beyond his mandate and invoking a law that hasn't been used since the 1960s so the Fed can become the creditor for an institution that attempted to enrich itself through wild speculative bets on dubious toxic investments which are now utterly worthless. If that isn't a good enough reason for abolishing the Federal Reserve; then what is?

The world's most transparent and profitable markets have been transformed into a carnival sideshow managed by hucksters, flim-flam men, and rip off artists. The Bear bailout is yet another glaring example of a system that lacks all credibility and is quickly self-destructing.  

By Mike Whitney

Email: fergiewhitney@msn.com

Mike is a well respected freelance writer living in Washington state, interested in politics and economics from a libertarian perspective.

Mike Whitney Archive

© 2005-2019 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.


Post Comment

Only logged in users are allowed to post comments. Register/ Log in