Derivatives and the Credit Bubble
In principle, there is absolutely nothing wrong with derivatives. They serve a valuable function, by transferring risk from those who don't want to be exposed to it to those who are willing to take risk on in their stead for a fee. However, since the adoption of the pure fiat money system, credit growth has literally gone “parabolic” all over the world. This growth in outstanding credit has been spurred on by interest rates that have been declining for more than three decades.
Larger and larger borrowings have become feasible as the cost of credit has fallen, and this has in turn spawned an unprecedented boom in financial engineering.
When critics mentioned in the past that this had created systemic dangers, their objections were always waved away with two main arguments: firstly, the amount of net derivatives exposure is only a fraction of the outstanding gross amounts, as so many contracts are netted out (i.e., things are not as bad as they look). Secondly, the system had proven resilient whenever financial system stresses occurred. Perhaps not as resilient as it seemed, considering that these crises as a rule required heavy central bank interventions and/or bailouts in various shapes and forms. Would the system have been as resilient if those had not occurred? We have some doubts with regard to that.
Then came the 2008 crisis, which underscored that the critics had actually been right about a major point: the system depends on almost everybody in the chain performing. It doesn't matter if one holds a contract that is in theory netted out if one party to it fails to pay up. One of the reasons why AIG was bailed out (or rather, its creditors were), was no doubt that the authorities feared that the failure of such a large player could snowball into cascading cross-defaults, and completely shatter trust in the system's “resilience”.
We still remember a few funny anecdotes that preceded the actual crisis point. One was that Fannie Mae – the eventual bankruptcy of which was predicted by Doug Noland almost a decade before it happened – had to hire some 2,000 outside accountants to sort out its more than 20,000 different derivatives positions, over which no-one at the firm had any overview anymore. The accountants were at work for at least half a year if memory serves.
Another was when AIG's board first realized it had a problem with its CDS positions in early 2008. What was so hilarious was that while they were already in the hole by billions at the time, they couldn't tell by how many. The board erroneously concluded that while the insurance giant was wounded, it was not mortally wounded. This view was revised rather dramatically within three months of the comical press release in which it was announced that the board didn't really know how big AIG's mark-to-market loss was (it was clear though that it kept growing by the day).
Picking Up Pebbles in Front of a Steamroller
AIG's experience is relevant insofar, as the institution was in fact “picking up pebbles in front of a steamroller”. It had a star trader in London by the name of Joe Cassano, who was in charge of the CDS business. He must have figured that since AIG was an insurer, writing insurance was what it should do. The problem was that at the height of the Greenspan policy inspired real estate and mortgage credit bubble, everything seemed to be perfectly fine with the world. Credit spreads were tight; junk bond yields were at record lows; structured credit products backed by NINJA mortgages of the sub-prime and 'Alt A' variety were stable and sought after. There was no volatility, and no volatility premiums. So the only way to make serious money was by making it up with volume. If one can sell a 5 year CDS at 50 basis points, one needs to sell sizable volumes to actually make enough money to earn a big bonus (e.g. 5 year CDS on Greek debt once traded just above 30 basis points in 2007. They went out at over 26,000 bps. just before the underlying debt was PSI'd).
Apparently this seemed reasonable to all involved. Writing CDS was practically viewed as getting something for nothing. Cassano and other prominent CDS writers at the time found many imitators all over the world (a number of which keeled over in the end). The reason why it seemed so reasonable was that the markets appeared to be indicating that there simply was no risk. Remember, very low credit spreads, no volatility, no defaults in sight anywhere…apparently no-one considered the possibility that these might actually be contrary indicators.
No-one seems to have bothered to look at the main wellspring of the credit bubble either: money supply growth. By 2006/7, the bubble in credit and assets was only kept afloat by the lagged effects of the massive burst in money supply growth Greenspan had egged on in 2001-2003 (at one point, broad money TMS-2 grew at nearly 20% annualized in this early inflationary spurt). By 2006/7 money supply growth had slowed to the low single digits – as good as a guarantee of an imminent economic and financial bust.
The y/y growth rate of money TMS-2 (without memorandum items) over the past 17 years – rising money supply growth produces asset bubbles, once the growth rate declines sufficiently, severe busts begin. The difference when including memorandum items is only very slight (a chart of nominal TMS-2 with memorandum items is in the addendum) – click to enlarge.
These things are important to keep in mind, because markets are currently sending exactly the same message: credit spreads are extremely low, there is no volatility (in fact, volatility indicators are at or near record lows in virtually every financial market segment, including foreign exchange), and corporate defaults are at record lows. Naturally, more of the same is “predicted” for as far as the eye can see.
There are however two major differences between today and 2006/7. One argues in favor of this happy state of affairs continuing for a while yet; money supply growth remains fairly brisk, although its larger trend is pointing down (see chart above). The other difference is more ominous: administered rates are at zero, and other interest rates seem about as low as they can possibly go. Contrary to previous times, this means that there is only one direction for them left to go – and that is up. Of course, as we have pointed out previously, no-one currently expects any problems with “inflation”, and hence it is assumed there won't be any interest rates-related upset either. Concurrently, both government and corporate debt around the world are at new record highs.
Interest rate derivatives – the biggest part of the pile – click to enlarge.
US non-financial corporate debt – the biggest bubble in corporate debt in history. Note that while bank credit expansion to the corporate sector is negative in Europe, junk bond issuance in Europe is at record high levels as well, exceeding previous records by a vast margin – click to enlarge.
Dining on a Fresh Menu of Credit Derivatives
Has anything been learned from the 2008 fiasco? Probably not. This is to say, it seems quite certain that the same kind of crisis won't happen again – this time it will be different in several respects. It will very likely also be worse, as the expansion in the money and credit supply has been even more intense than in the last bubble. Financial engineering hasn't really taken a breather either. As the Financial Times recently reported:
“In March of last year, Kyle Bass, founder of the hedge fund Hayman Capital Management, made a startling proclamation: aggressive young bankers in Japan were pushing complex over-the-counter derivatives similar to those that rapidly soured during the financial crisis of 2008.
Mr Bass warned of the return of the spectre of AIG, the giant insurer that required a huge bailout during the depths of the crisis, after selling billions worth of credit default swaps (CDS) that offered payouts to investors in defaulted mortgage bonds.
That warning appears sagacious, with investors once more chasing levered returns via certain types of US credit derivatives that Wall Street is willingly providing in the current climate of low interest rates and moribund volatility.
Some market participants say the rise of these derivatives raises questions about the effectiveness of financial reform undertaken since 2008. While standardized derivatives such as interest rate swaps are now transacted in exchange-type venues and centrally cleared, the flourishing area of opaque products are not, and moreover there are few records of activity that regulators can monitor.
“We’ve reformed nothing,” says Janet Tavakoli, president of Tavakoli Structured Finance. “We have more leverage and more derivatives risk than we’ve ever had.”
Proponents say bespoke instruments are playing a prime role in allowing investors to “hedge”, or offset, increasingly large positions in the debt markets. But in the current environment of low volatility and meager returns, the risk is that the strong growth in the use of complex derivatives may compound the next major market reversal.
The danger, as demonstrated vividly during the financial crisis when Lehman Brothers collapsed, is how complex credit bets can unravel and prove enormously costly for investors once market volatility erupts.
“The markets don’t really need a Lehman or even Lehman-lite event for a credit dislocation,” says Manish Kapoor, managing principal at hedge fund West Wheelock Capital. “You just need spreads to widen out or rates to go up for a significant impact on collateral movement for derivatives.”
The renewed boom in credit derivatives is being powered by yield-hungry investors and Wall Street banks looking for new revenues. The two instruments helping investors play booming corporate credit markets at this juncture include total return swaps (TRS) and options on indices comprised of credit default swaps.
The use of options tied to CDS indices, known as “swaptions”, has grown sharply, buoyed in part because the instruments are not required to be centrally cleared. Such swaptions allow investors to protect their portfolios from large movements in markets, known as “tail risk”.
More than $60bn of CDS index options currently exchange hands each week – up from just $2bn traded per month back in 2005, according to Citigroup analysts.
The article incidentally bemoans that regulators have no way of controlling or watching these markets of increasingly exotic hedge instruments. We would contend that this doesn't make one iota of a difference. Were they not “watching” the mortgage credit bubble in 2003-2007? Of course they were. After all, the bubble played out in one of the most heavily regulated and subsidized markets. They just didn't think anything untoward or dangerous was happening. One only has to revisit the appallingly wrong real estate market predictions of Mr. Bernanke to see this. To call that man utterly clueless before the event is almost too kind a description. Naturally, his views reflected those of the entire gamut of regulators and central planners, who were to the last man equally clueless.
In case you are wondering if anything has changed in this respect, the answer is a resounding no. After having nearly doubled the money supply since 2008 and having caused massive asset bubbles in the process, Fed members and other officials once again regularly declare that nothing can possibly be amiss.
Junk bond yields and the effective federal funds rate. Periods of low spreads and low volatility create complacency and make it difficult for the writers of 'insurance' to make money – so they will sell all the more of it. At the same time, investors are boosting their meager returns by leveraging their positions – click to enlarge.
As the highlighted passages in the excerpt from the FT above show, not only has trading in highly leveraged and increasingly exotic products exploded, there is the important point that the market has become intensely vulnerable to rising rates. Of course, no-one knows where the systemic weaknesses are hiding this time, just as no-one knew last time around. We will only know who's swimming naked when the tide goes out again, but we can be sure that a few institutions clad in their birthday suits will be dotting the landscape when the time comes.
We mentioned the AIG drama inter alia to stress this particular point: back when AIG began to get into trouble, it surprised nearly everybody. In fact, when the problems first became evident, many argued that the stock was a good buy because it presented “value”. It was widely held that this behemoth of the insurance industry could not possibly be felled by a few souring CDS positions.
As we pointed out in “A Dangerous Boom in Corporate Debt”, there are very large market segments that are far less liquid than they once used to be, mainly as a result of banks ceasing quite a bit of their proprietary trading activities. So what will happen when the herd that is up to its eye-brows in the return-free risk segment known as junk bonds tries to exit?
Many investors no doubt have hedged their positions or are actively betting on a dislocation for the simple reason that it costs almost zilch to do so. The question will once again boil down to whether all the writers of this insurance will be able to perform. It should also be noted that equity markets are definitely linked to the fate of the credit markets. Not only are record share buybacks depending on corporations taking on ever more debt, but the players in the stock market are likewise leveraged to the hilt (as evidence by the enormous growth in margin debt). Moreover, there is no escaping the interconnectedness of different financial market segments – troubles in one will inevitable spill over into others, as a scramble for liquidity will ensue once the problems begin.
As we always point out, there is no way of telling how long the current blissful state of affairs will continue. Much will depend on the trend in money supply growth and where the 'threshold level' for crisis will turn out to be this time around. However, we do know one thing: it isn't different this time.
Many seem to believe that the bubble's amazing resilience to date is a sign that it cannot possibly run into trouble. That will turn out to be a potentially costly error at best. In fact, the longer the period of compressed spreads and low volatility lasts, the more forceful the eventual denouement is likely to be.
Addendum: TMS-2, Complete
We have recently often posted charts of money TMS-2 excluding memorandum items, noting that they amount to approx. $50 billion. The reason is that we can get a more timely chart that way (as some data are updated weekly, while others are only updated monthly) and don't need to add the six different memorandum items that need to be included, which is rather time consuming. We usually do an occasional quick scan of them in order to see if anything unusual is transpiring. Our estimate was a bit off the mark as it turns out. The actual difference is about $88 billion at the moment – however, since we are dealing with a total amount of $10.354 trillion, it is still marginal and can be disregarded if one wants to take a quick look at the data. Anyway, here is the total money supply TMS-2 as of July 2014:
TMS-2 including memorandum items. The composition is: currency, demand deposits, savings deposits (but no time deposits – only the type of savings deposits that are in actual practice available on demand), demand deposits due foreign commercial banks, demand deposits due foreign official institutions, treasury demand deposits at commercial banks and treasury note balances at depository institutions, and the general account of the treasury at the Fed – click to enlarge.
Bonus Chart: Leveraged Debt Outstanding:
Total leveraged loans outstanding. For a backgrounder on this type of debt see here.
Charts by: St. Louis Fed, Marketwatch, BIS, Morgan Stanley
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