The Pitfalls of Derivatives

Many people, by what I read in articles and responses in the blogging world, seem to think MBS, and CDO's and other derivatives are the same. There is a distinct difference. This difference, understanding it, and how it came to be may shed light on a somewhat confusing subject. It is also why I believe everyone should be a little more concerned right now.


A little history as backdrop

I began talking of the pitfalls of derivatives in 1998, after the demise of Long Term Capital Management. LTCM was only one hedge fund. Its purchase and issuance of derivatives, and its subsequent collapse, caused worldwide panic in the financial markets. 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. Bankers Trust, Barclays, Chase, Credit Suisse First Boston, Deutsche Bank, Goldman Sachs, Merrill Lynch, JP Morgan, Morgan Stanley, Salomon Smith Barney, UBS and other firms, all kicked in to cover the losses suffered by LTCM, and thus prevented systemic financial fallout from occurring. Understand, the money they put in, they never got back. They knew they would never get it back. These banks knew they had just stopped a meltdown of the entire financial system from occurring.

The flight to liquidity during the bursting of the tech bubble caused the collapse of LTCM. Investors sought the cash from their positions with LTCM. As LTCM tried to liquidate, or sell in layman's terms, the derivatives they had, these derivatives were returning far less than the value LTCM claimed they held. So, if someone had invested $1000 in a derivative with LTCM, they might get $200, $400 or $600 depending on which vehicle they had bought. Quite a loss from a firm that claimed to offer 40% returns.

At the same time, 1998, Senator Phil Gramm of Texas lobbied for the bill that would remove the last vestiges of the Glass-Steagall Act of 1933. (There was a second Glass-Steagall Act otherwise known as the Banking Act of 1935.) Glass-Steagall required banks to create separate businesses for deposits of savings and deposits for investments.

In 1999, President Bill Clinton signed into law the Gramm-Leach-Bliley Act which repealed the Glass-Steagall Act of 1933. Now, banks could mix assets held in their commercial banks with assets held in their investment banks. The Gramm-Leach-Bliley Act allowed commercial and investment banks to consolidate.

Deregulation of the energy and telecommunications industries in the late 1990's ran unabated. Coupled with the Gramm-Leach-Bliley Act, a toxic brew of new accounting opportunities opened for large corporations. Exemptions from accepted accounting practices could now be given.

Wendy Gramm, then head of the Commodity Futures Trading Commission and wife of Texas Senator Phil Gramm (the second-largest recipient of Enron campaign contributions), granted Enron an exemption from government disclosure rules at the company’s request; shortly afterward, she resigned from the CFTC and joined Enron’s board of directors.

We all know how that turned out.

Funny thing is, Phil Gramm is now a lobbyist for UBS, the large Swiss bank recently under scrutiny by the SEC for teaching wealthy American clients how to create overseas accounts to hide profits for the purpose of avoiding taxes.

Phil Gramm is also John McCain's lead economic advisor.

So, with all of these changes to economic policies, the stage was set for expansion of risky financial vehicles that the banks could sell for huge fees.


MBS and the derivatives built on them

There are somewhere around $600 Trillion in derivatives, globally. Most are built on the backs of US Mortgage Backed Securities and other debt such as credit card debt, auto loans, and even student loans.

MBS are derivatives of the first order. The issuer of the MBS gathers multlple mortgages, usually similar in nature (ie. Nov. 2006 first lien ARMs) and bundles them together. The bundles can represent $20 million, $100 million or more in mortgages. This is called securitizing, and creates a bond for the issuer to sell. This new bond of MBS actually owns the underlying mortgages. Should a mortgage contained within an MBS go into default, and subsequently be liquidated, through short sale or foreclosure sale, the MBS is first in line to get the money from those proceeds.

CDO's, CLO's, CMO's, SIV's and the like are derivatives of the second order. A CDO is usually made up of several MBS issues, each portion called a tranche. Each tranche is calculated to offer a certain rate of return. Most often, a few of the tranches in a CDO have very risky MBS, such as subprime mortgages, which have a higher rate of return, thus raising the overall rate of return of the CDO. CDO's squared, and all things similar, are derivatives of the third order. CDO's squared contain two or more CDO's put together.

All derivatives of the second order are bets on the performance of the underlying MBS or whatever debt is contained in the original securitization. All derivatives of the third order are bets on the performance of derivatives of the second order.

MBS and CDO’s are distinctly different, and I believe many people are not realizing that yet.

$ 13 Trillion MBS. $ 600 Trillion Derivatives. Is it sinking in yet?

Most of the twenty-five largest banks have exposure to derivatives and blown MBS representing 300%, 400% and some many more times, their hard assets. Chase is the single largest holder of derivatives in the world. There are somewhere around $600 Trillion in derivatives, globally. Most are built on the backs of US MBS and other debt. In Sept 2007, Chase had $92 Trillion in derivative holdings, almost 1/6 of all derivatives. Their hard assets in Sept 2007 were $ 1.3 trillion.

Theoretically, even with only a haircut of 5%, on paper, they are insolvent. The losses on derivatives, as a whole, will be no less than 50% across the board. They are bets on the performance of MBS. The derivatives of the second or third order do not own the mortgages, they are only bets on the performance of those mortgages contained in the original MBS. The MBS is still there, intact, and it owns those mortgages. The owner of a CDO cannot assume the property of a foreclosure represented within one of its tranches, because the CDO is only a bet on whether that mortgage would perform and reach maturity.

Already proven in court in Cleveland, CDO's have no claim to the underlying mortgages. The owners of over $1 billion in CDO’s tried to get the foreclosed properties represented in the issues they bought. The judge, once it was explained to him what the CDO’s were, laughed and tossed their case out. The attorneys could not produce any documents to show the owners of the CDO’s held the notes to those properties, because they don’t. The holders of the underlying MBS to those CDO’s hold the notes, and they aren’t giving them to the buyers of CDO’s.


Do not bet against Chase

I am not saying Chase is going bankrupt or will be taken over, exactly the opposite is true. Chase will be one of the big boys gobbling up damaged banks and other damaged assets. But, it is not due to their being healthy, it is due to the fact they are the largest shareholder of Treasuries held by the Federal Reserve. Other banks are not in the position of control that Chase and a few others are. Do bet against the banks that do not have the control, for they will be acquisition targets.

The Fed, if the worst case should happen with our economy, will be forced to draw a line in the sand. The entities on the correct side of that line in the sand, determined by their ownership of treasuries held by the Fed ,will be protected at all costs. Those not on the correct side of the line in the sand are a target to be taken over as they get hammered by writedowns.

Right now, it is a good guess that only three entities are on that correct side of the line in the sand. Chase, BofA and Citi. Citi will have more money from the middle east pumped into it. I do not like that two people from the Middle East now own 10% of Citi. Get ready, they are going to own at least 20% by the end of this mess. The Fed will use every resource to protect Chase and BofA. Why, because they will use the Treasuries that Chase and BofA own to protect them.

Almost all Derivatives built on MBS will return at best, 50 -60%, and only a small fraction will do that. Derivatives that include other debt such as credit cards and auto loans, forget about it. There will be some value, but it will be somewhere between 10 -25% by the time they can be liquidated. The Fed is allowing banks to now securitize auto loans, credit card debt and other junk, and exchange it with the Fed for US treasuries, which the bank can then go borrow against. The Fed, before the swaps, had around $800 Billion in US Treasuries. More than $240 Billion in the last 6 months has been swapped.

It is the exact amount that futures trading on commodities has gone up since January. So, when people scream about speculators driving up oil, it is the banks that are most in trouble that are the speculators. How do you like those cookies? Creating another bubble. What happens if oil retreats back to $110? Massive losses. Of borrowed money. Of borrowed money guaranteed by US Treasuries swapped with the Fed for dubious debt that might get 50 cents on the dollar.

Any losses of those treasuries will be replaced not by Chase or BofA or any other bank party to the swap, but with taxpayer money.

As for my prediction on what will happen - nobody has a crystal ball, but the losses are already there and being hidden in level 3. Everyday that property values decline, those losses increase. If the assets in level 3 are hedged with a commodity, such as oil, and it falls from a pop of the bubble, the losses are magnified. There is a good case for an L shaped recession such as Japan has experienced over the last decade or so. The problem with comparing it with our current circumstances is that our overall losses, due to derivatives, are a few thousand times greater.

A depression, maybe, if the Fed doesn’t stop with the swaps it is almost guaranteed.