The Derivative Mess

The reason that stock prices continue to gyrate so much as they head down and the credit markets still are frozen – even after unprecedented action by the Fed and worldwide central banks – all is captured in a single phrase – the derivative mess.

The Size of the Problem
That is why I am repeating the picture above because it tells the story. Now many of these swaps cancel each other out – but there is  an overhang estimated at between $4 to $12 Trillion depending on which international financial agency does the counting.  There is $50 trillion++ of CDS-Collateralized Debt Swaps of which a significant fraction are toxic. But no financial institution can unravel how many and how badly their CDS “assets” have turned. This is the thrust of the problem that adding liquidity will just not solve right away. Financial institutions are unable to valuate their “assets”. Particularly their drivatives or swaps. Thus Ben Bernanke is not kidding when he says the recovery processes is not months but more likely quarters if not years in length.
What makes the situation so galling is that the Financial Markets have already had a run in with this financial bubble before. In 1998, losses due to the same causes – highly leveraged, derivative “buys” increasingly in vehicles that are complex and hard to price, and highly illiquid especially when one player dominates the market. Long-Term Capital in 1998 shook the very foundations of Wall Street with its bankruptcy in the face of taking a series of unanticipated and cascading risks with their derivative instruments.

And so Wall Street had a hard failure and precusor experience that should have taught the institutions a lesson. Over and over we are told by financiers that they are Darwinian and efficient – they learn and fast from from their mistakes. Thus, let me repeat that Wall Street Bankers and Hedge Fund excutives should have known better to get themselves involved in the Housing/Mortgage bubble.

And Wall Street executives even had a book that spelled out all the problems in detail – Richard Lowenstein’s When Genius Failed. These were University professors and Nobel Prize geniuses who succumbed to making highly leveraged derivative bets that eventually went beyond their hundreds of millions capital means. Move forward 10 years and Wall Street repeats the same mistakes. Darwinian efficiency be damned – Wall Street players were greedy blind to their vulnerability when they should have known batter. After all the CDS were the same type of complex derivatives whose complex intertwinings negated the very risk dispersal CDS were designed to deliver. And of course the huge leverage of 20-1 up to 40-1 had already failed catastrophically. The Rise and Fall of Long-Term Capital had already told us what Wall Street has visited on not just the US but the whole world =>A wrenching financial debacle of the same ingredients (thanks again you over-compensated Greedy Guts): the derivative-based, highly leveraged hedge fund that failed spectacularly in 1998 has all the “earmarks” of ten years later and the 2008 Mortgage Meltdown.
Just reading through the book many of the same players and same causes are on stage. Exceedingly high leverage plus complex hard-to-value derivatives are there for all to see. But perhaps the most telling problem is the overwhelming secrecy in which trillions of dollars of swaps are done without control or scrutiny by either the Financial Communty or their Regulators. In effect, the Dark Matter Financial Markets which the Economist warned about a year and half ago have come back to bite not just Wall Street but the whole world that adopted many of the swaps, derivatives and other financial instruments of darkness. Fiduciary Trust be gone as much of this is own account work by the banks, funds and institutions. And its also Shark Chum Greed for outlandish compensation that has helped to energize the notion that one can perpetuate outsized returns. Heaven forbid he who has to solve this Wicked Problem because the Financial Sharks are still armed with ill-gotten millions if not billions.