(Global Debt Crunch) Daisy-Chain - By Doug Noland
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(Global Debt Crunch) Daisy-Chain - By Doug Noland

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"The Credit system is today an incredible mess. Literally Trillions of securities, previously valued in the marketplace based upon confidence in the underlying financial guarantees, are now suspect. This has severely impacted marketplace liquidity. And perhaps tens of Trillions of Credit and other derivative contracts are now subject to very serious counterparty issues. Many players throughout the Credit market are now severely impaired and have lost the capacity to hedge against/mitigate further losses.

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...“Contemporary finance” is being exposed as a daisy-chain of interrelated risks and fragilities.
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Daisy-Chain

By Doug Noland
January 18, 2008
Source

The financial crisis took another giant leap this week. Credit insurer (“financial guarantor”) Ambac lost its AAA rating (from Fitch), in what will mark the onset of a devastating run of downgrades for the likes of Ambac, MBIA and the entire industry. The “monoline” insurance business, as we’ve known it, is done and the value of the insurance they’re written is evaporating by the day. The market is now desperate to determine which financial institutions (and there are many) have purchased large amounts of (now suspect) insurance for hedging purposes, as well as other financial companies that have in one way or the other participated in the Credit “reinsurance” market.

Virtually all the major financial players are embroiled in this Systemic Credit Fiasco. Importantly, the mind-blowing demise of the “financial guarantors” is fomenting a crisis of confidence in Credit insurance in all its various forms (certainly including the Credit default swap (CDS) and MBS guarantee markets). I’m assuming that our policymakers will attempt to throw together some type of industry recapitalization strategy, although the complexity of the issue leaves one perplexed as to how any bailout plan would be structured. I suspect that our federal government will eventually be forced to enter the “financial guarantee” business, at least to the point of assuming the obligations of municipal bond (from the “monolines”) and mortgage-backed securities (from the GSEs) insurance.

The Credit system is today an incredible mess. Literally Trillions of securities, previously valued in the marketplace based upon confidence in the underlying financial guarantees, are now suspect. This has severely impacted marketplace liquidity. And perhaps tens of Trillions of Credit and other derivative contracts are now subject to very serious counterparty issues. Many players throughout the Credit market are now severely impaired and have lost the capacity to hedge against/mitigate further losses.

To be sure, Discontinuous and Illiquid Markets have Wreaked Bloody Havoc on “dynamic” trading strategies used commonly to hedge various risks. I don’t believe it is hyperbole to suggest that “dynamic hedging” (in particular shorting Credit instruments to provide the necessary cashflows to pay on Credit derivative contracts written) became the critical linchpin of contemporary Wall Street risk intermediation. Yet today the models behind so many strategies that have come to permeate “contemporary finance” have completely broken down; the strategies of thousands of financial institutions - big and small - have turned infeasible.

From a macro perspective, Wall Street Risk Intermediation has essentially crashed and the “risk markets” essentially “seized up.” Almost across the board, the major risk operators are moving aggressively to rein in risk-taking. The leveraged speculating community is in turmoil. The “quants” are in a quandary. Basically, the entire market today desires, at least to some extent, to reduce/mitigate/transfer Credit and market risk. Inevitably, however, when “the market” is keen to hedge there’ll be no one with the necessary wherewithal to take the other side of The Trade. I have so many fears I don’t even know where to begin, although I will say that I am less than comfortable these days discussing individual companies. Tonight the (brief) analysis will be in generalities.

There are scores of financial players – from small hedge funds to the major “money center banks” – with complex books of derivative trades that now have a very serious problem. These “hedged books” contain various supposedly offsetting risk exposures that, in there entirety, were to (through financial “alchemy”) have created a reasonable and manageable portfolio risk profile. But the breakdown in Wall Street finance has transformed these too often highly leveraged “books” into essentially unmanageable “toxic waste” and financial landmines.

First, correlations between various instruments have broken down (i.e. junk bond spreads widen while “dollar swap spreads” narrow). Second, the liquidity profile (hence pricing) of various sectors has diverged radically (i.e. agency MBS vs. “private-label” MBS/ABS). Third, with the breakdown in Wall Street’s “private-label” MBS market and the collapse in confidence in the “monoline” Credit insurers, liquidity has all but evaporated throughout huge cross-sections of the debt securities and related derivatives markets. This dynamic is fomenting dangerous counter-party risks and uncertainties. The capacity of a rapidly rising number of market participants to fulfill their obligations in various types of derivative and “insurance” contracts is in question.

Imagine you have a “hedged book” of securities and derivative – for example a portfolio of CDOs hedged with Credit Default Swaps (CDS) from one of the “monoline financial guarantors.” Today, the value of your CDO portfolio is declining while the “value” of your offsetting CDS hedge is impaired by the increasing likelihood of a default by the “monoline” (who provided the CDO default “insurance”). The reality is that the hedged position has broken down and risk now rises by the day. And, unfortunately, your options are decidedly limited - there is little if any liquidity to sell the underlying CDO. One could go into the market and attempt to buy additional protection, although in many cases the cost would be prohibitive. Besides, there’s today little assurance that counter-party risks wouldn’t emerge in the second hedge as well.

The Wall Street firms and many of the more sophisticated hedge funds run very complex “books” of securities and derivatives. The dilemma they face today is commensurate with the complexity of their strategies. Recent developments – in particular heightened marketplace illiquidity, rising probabilities of “monoline” defaults, dislocation in the CDS markets, and a breakdown in typical correlations between instruments/sectors/markets – makes the job of effectively comprehending, quantifying, analyzing and managing risk impossible. Do the managers, then, attempt the highly problematic task of recalibrating hedges based on current conditions (i.e. spiking hedging costs, likely counterparty defaults, and recent market correlations) and risk compounding the problem if market conditions begin to normalize? Is it feasible for these players to recalibrate hedges, knowing full well that our well-intentioned policymakers are destined to intervene clumsily in the marketplace?

It is difficult for me to see how the leveraged speculating community is not in serious jeopardy. It became all too commonplace to leverage illiquid (and difficult to price) securities, while even the previously liquid markets today barely trade. Few speculative Bubbles in history were as vulnerable to a “run.” None were remotely as gigantic or global in scope. This “community” creates (systemic) worry because of the vulnerability of losses and resulting redemptions creating panic dynamics. Today, market illiquidity increases the likelihood that many funds will be forced to halt redemptions. This dynamic has commenced and it holds the potential to batter industry trust and confidence.

The leveraged speculators create various systemic risks. Their desire to hedge risk exposures – as well as seek speculative profits – during market turbulence has certainly exacerbated the Credit Crisis. During the cycle’s upside, their desire to leverage securities greatly amplified the liquidity bull run. Today, their selling/deleveraging/hedging foments liquidity crisis and panic. Importantly, the speculators are today keen to short stocks, sell futures, and purchase equity put options. The “hedge funds” have, after all, sold themselves as capable of minting money in any kind of market environment. All the same, a major systemic dilemma is unfolding.

Leveraged speculator dynamics in concert with a Bursting Credit Bubble now places enormous stains on the stock market. Not only have faltering Credit Availability and Credit Marketplace Liquidity dramatically diminished the prospects for companies, industries and the general economy. Limited liquidity in the Credit market has also created a backdrop where those seeking to hedge (or profit from) heightened systemic risks have few places to go for relatively liquid trading outside selling stocks and equity index products. And sinking stock prices further aggravates the unfolding Corporate Credit Crisis, fostering only greater systemic stress and only greater selling pressure. “Contemporary finance” is being exposed as a daisy-chain of interrelated risks and fragilities.