SPX off 25% since Lehman bankruptcy

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Quote of the day - its the c-banks fault!

European Central Bank Governing Council member Miguel Angel Fernandez Ordonez said Thursday the world's developed economies face a deep slowdown. In his opinion the world's central banks are to blame for the global financial crisis. I guess we all know the major recipient of his message!
Does he think that low interest rates rather than lack of regulation are to blame? There is at least one smart central banker.

"This global, accommodative period, the risks of which were highlighted by some economists at the Bank of International Settlements, surely was the most important factor contributing to the crisis".

CDS settlement and Lehman - the eye of the storm

CDS settlements are pivotal if one strives to understand the current capital market crisis caused by a severe debt crisis. Yves Smith, creator of the most excellent blog "naked capitalism" sheds light on an interesting link between credit default swap settlements and interbank market rates like LIBOR by referencing a discussion in the current issue of the Institutional Risk Analytics. One of the few positive news in the last couple of weeks coming from Don Donahue, CEO of DTCC, is being challenged. To refresh memory, the DTCC claimed that the net payments on Lehman contracts were a mere $6 billion. This is only part of the truth according to the article since a large number of total holders of CDS for Lehman do not wish to take cash settlement and are expecting to receive the underlying bonds instead. The actual funding needs for CDS contracts linked to Lehman debt might therefore have been closer to the initially suggested $300 billion. This horrible number makes much more sense in light of the devastating effect in interbank lending markets after the surprised Lehman collapse. In the wake of the bankruptcy European Central Bank President Jean- Claude Trichet said U.S. lawmakers must pass a $700 billion rescue package for banks to shore up confidence in the global financial system. ``It has to go, for the sake of the U.S. and for the sake of global finance,'' Trichet said quoted by Bloomberg.

Here are the key passages:
This process of funding the CDS is reportedly a factor behind the high rates of dollar LIBOR in London and illustrates how cash settlement derivatives actually multiply risk without limit. Through the wonders of cash settlement, the derivative-happy squirrels at the Fed, BIS and ISDA created a liquidity-sucking monster in OTC derivatives that multiplies risk many times, for example, above the amount of underlying debt of Lehman Brothers.

We hear that there are more than a few EU banks which wrote CDS on Lehman over the past several years, CDS which were written at relatively tight spreads. These banks did not participate in the DTCC auction and instead have chosen to take delivery on the Lehman debt, forcing them to fund a nearly 100% payout on the collateral. A certain German Landesbank, for example, took delivery on $1 billion in Lehman bonds that are now worth $30 million, and had to fund same. Does this example perhaps suggest a reason why the bid side of dollar LIBOR in London has been so strong?

....the normal operation of the OTC derivatives markets is creating a cash position that must be funded in the real world and is thus distorting these benchmark cash markets such as LIBOR. This distortion is magnified by the dearth of liquidity due to the breakdown in the rules regarding valuation and price. So far, the Fed and other central banks have addressed the on-balance sheet liquidity needs of global banks. But as retail and corporate default rates rise, funding the trillions of dollars in notional off-balance sheet speculative positions in CDS, which become very real and require funding when a default occurs, could prolong the economic crisis and siphon resources away from the real economy.

On September 15 Lehman filed for bankruptcy. A look at the EURUSD exchange rate might help to understand. Decoupling has been put to rest once and for all.
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source: How Credit Default Swap Settlements Are Draining Liquidity From Interbank Market
Yves Smith, naked capitalism, Oct 29, 2008
http://www.nakedcapitalism.com/2008/10/how-credit-default-swap-settlements-are.html

source: In the Fog of Volatility, the Notional Becomes Payable, A Black Hole for Liquidity?
IRA, October 27, 2008
http://us1.institutionalriskanalytics.com/pub/IRAMain.asp

CBOE volatility index at all time high!

A prominent fear gauge, the CBOE volatility index (VIX) reached 89.53 last week and demonstrates how a high level of uncertainty has infused capital markets. Put buyers are committed to pay outsized premiums to protet their investments. Other volatility indicators are also elevated. VIX's predecessor, CBOE's VXO, which tracks projected volatility for the S&P 100 index .OEX options, surged 15.75 percent to 79.36. But it was well below the 150.19 reading set during the 1987 crash.

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A market veteran's view

A market veteran who obviously was a witness to the 1929 market crash and the following depression years thinks that the "market will turn around in a week or so". Let's see if he gets it right.

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source: On the verge of a new bull market?
Fox Business News
http://cosmos.bcst.yahoo.com/up/player/popup/index.php?cl=10403449

Global financial rescue plan - a drop in the bucket

Willem Buiter, Professor of European Political Economy @ the London School of Economics and Political Science, submits following "rather specific" action plan to solve the financial crisis:

(1) Public guarantees of interbank lending between banks in different national jurisdictions. This could be implemented by national central banks acting as counterparty of last resort in the (unsecured) interbank markets.

(2) International agreement on limits on public guarantees for other bank liabilities and for liabilities of other highly leveraged institutions. This includes agreements on terms and conditions attached to such guarantees.

(3) International agreement on recapitalisation of banks with significant cross-border activities.

(4) Fiscal bail-outs of countries whose systemically important banks have a solvency gap that exceed the government’s fiscal capacity.

(5) International agreement on mandatory debt-to-equity conversions for banks and other highly leveraged institutions.

(6) International agreement on avoiding a moral hazard race to the bottom for deposit insurance through limits on deposit insurance (this is really as special case of (2)).

(7) International agreement on common access rules and common methods for valuing illiquid assets in different national TARP-like structures.

(8) International agreement to adhere rigorously to mark-to-market accounting and reporting principles and on common rules for relaxing regulatory requirements attached to marked-to-market valuations.


Buiter comes up with a great action plan, but I am not sure if it would solve the problem. In order to do just that first we have to understand what the problem is. Nouriel Roubini calls it the "mother of all bank runs", a run on the shadow banking system of over the counter derivative contracts called credit default swaps (CDS). The size of this unregulated market was $62 trillion at the end of 2007. It therefore by far exceeds all government measures combined.

Last Friday CDS contracts with bankrupt Lehman were auctioned at less than 10 cent on the dollar, which means that counterparty obligations are more than 90 cents on the dollar. Now everybody wants to get out and CDSs are sold at fire sale prices. This is eroding the capital of banks and drives them into bankruptcy. All the government actions combined cannot stop it because the capital injections are insufficient.

Instead of focusing only on capital injections we should also convene a global international banking conference, where CDS contracts will be mutually canceled. After all they have been agreed upon over the counter, it should be possible to cancel them the same way. The number of banks could be limited too, since only large banks are system relevant. Nevertheless every bank should be allowed to participate and CDS should be worked off contract by contract.

We all witnessed the carnage on the balance sheets of banks when subprime securitzed mortgage loans were sold at fire sale prices. The subprime market was $1.5 trillion. Now we are in the middle of face two, the selling of CDS contracts at fire sale prices. Only this time the market is about 50 times larger. Without global agreement on canceling this contracts the meltdown will continue.




source: Action plan - my foot
Financial Times, Maverecon Blog, Willem Buiter
http://blogs.ft.com/maverecon/2008/10/action-plan-my-foot/#comment-5245

RGE monitor
Nouriel Roubini
http://www.rgemonitor.com/

You Know times are different

when villains try to become saints. Criminal narrator boosting crude, aka CNBC, is pleading to CEOs of financial firms to become clean and tell the truth. "It is your duty", says the anchor. Where were those converts when we needed them.
Witness this holy conversion on video here















source: An Open Invitation
CNBC managing editor Tyler Mathisen sends an open invitation to fund managers and other financial leaders to come on CNBC and discuss what's going on right now. http://www.cnbc.com/id/15840232?video=884904528

A day of reckoning for financial counterparties

From dailyfx.com:
"The auction of Lehman CDS contracts will be a major event today as it will determine the level of what will be the biggest CDS payout to date. The proximity of this may have been a big reason why credit markets have remained frozen despite the considerable policy interventions. Counterparty losses could be considerable; Lehman's $128 billion of bonds were trading on Thursday at an average of 13 cents on the dollar, suggesting credit swap sellers may have to pay 87 cents on the dollar to the buyers of default protection. More than 350 banks and investors have signed up to settle credit-default swaps tied to Lehman. Earlier this week the value for bonds of Fannie Mae and Freddie Mac were priced as low as 8.5 cents on the dollar, at most, because the debt is backed by the government."


update Oct.10 4:19 p.m.: What a day in the markets!
Bloomberg reports:
Sellers of credit-default protection on bankrupt Lehman Brothers Holdings Inc. will have to pay holders 91.375 cents on the dollar, setting up the biggest-ever payout in the $55 trillion market. Based on the results, sellers of protection may need to make cash payments of more than $270 billion, BNP Paribas SA strategist Andrea Cicione in London said. The potential payout is higher than the 90.25 cents indicated by initial results from the auction earlier today. Lehman bonds traded yesterday at 13 cents on the dollar, suggesting a payout of about 87 cents was expected.

The auction started at 10:30 a.m. and ended at 2:00 p.m. NYT. Here are a few charts that illustrate the disappointment and the relief-rally which underscores tremendous volatility and uncertainty in the markets. The clearing of Lehman's credit default swaps is an encouraging sign but it is only a first step towards functioning credit markets.
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The global credit crisis might be on the mend, at least for now. "Lehman credit default swap sellers posted collateral and no firms failed", according to a statement from the International Swaps and Derivative Association.



source: Lehman Credit-Default Swaps (CDS) Auction on Tap - Debt Insurers Expect Losses
dailyfx.com, Friday, 10 October 2008 07:19:43 GMT
http://www.dailyfx.com/story/market_alerts/fundamental_alert/Lehman_Credit_Default_Swaps__CDS__Auction_1223623206912.html

source: Lehman Credit-Swap Auction Sets Payout of 91.38 Cents on Dollar
By Shannon D. Harrington and Neil Unmack, Bloomberg, 10/10/08
http://www.bloomberg.com/apps/news?pid=20602007&sid=aLkOZnNcDmSQ&refer=govt_bonds

Warren Buffett's usual suspects - the three "I"s

Warren Buffett in his fine, crafty style demonstrates again why he is the most successful investor in the history of capital markets. In his conversation with Charlie Rose he is on the beat at the current crisis and he offers three "I"s as his usual suspects:

"The innovators, the imitators, and the idiots"

Keywords during the conversation:
bailout, credit crisis, philanthropy, wall st., Berkshire Hathaway, Melinda Gates, Bill and Melinda Gates Foundation, Warren Buffett, economy

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source: An exclusive conversation with Warren Buffett
Charlie Rose on PBS, 10/01/2008
http://www.charlierose.com/shows/2008/10/01/1/an-exclusive-conversation-with-warren-buffett