Adele Ferguson | October 18, 2008
Article from:  The Australian

IN 2002, legendary investor Warren Buffett warned that derivatives were time bombs and “financial weapons of mass destruction” that could harm not only their buyers and sellers, but the whole economic system.

Instead of heeding this oracle’s warnings, financial institutions rejoiced in these ticking bombs, which have now blown up, leading to estimates that the global banking system will lose up to $1.4 trillion before the crisis is over.

The world financial system is leveraged beyond comprehension. It is estimated that between $US500 trillion ($732 trillion) and $US700 trillion worth of derivatives are outstanding.

Compare this with the total economic activity (GDP) of the world, which is about $US50 trillion, and even a 5 per cent drop in the value of the derivatives is beyond the rescue capability of the world’s central banks, according to financial author Bert Dohmen in his Prelude to Meltdown.

These exotic and opaque financial instruments, which a year ago were almost unheard of, have become household names, as politicians appear on radio and television bleating about the $US60 trillion in credit default swaps (CDSs) slinking around the system, along with their retail cousins, collateral debt obligations (CDOs), many of which were sold to unsuspecting Australian charities and local councils — to their detriment.

The banks, in turn, are starting to come clean about their exposures, and more will be revealed when they release their results.

The latest Reserve Bank Bulletin reveals that Australian banks have more than $13 trillion in off-balance-sheet derivative exposures, compared with $5.4 trillion six years ago. If just 1 per cent of these blew up because third parties at the other end got into trouble, the whole shareholder wealth would be wiped out and the banks could be broke.

As total bank assets are $2.3 trillion, why do Australia’s banks have exposure to $13 trillion of derivatives positions? All banks hedge to reduce risk, but this is a great deal of hedging.

To put it in perspective, Australia’s GDP is about $1.3 trillion, our pool of investment fund assets is $1.2 trillion and the freely floated market capitalisation of the stock market is $1 trillion.

Right now, we are being told Australia’s banks are safe. Indeed, on Sunday night Prime Minister Rudd will front a television show with 100 Australians to answer questions about the financial system and try and quell fears that the wheels could fall off our banking system.

Hugh McLernon from litigation funder IMF, who has spent the past nine months looking at CDSs and CDOs as part of a case he is working on, said yesterday: “No matter who are the winners and losers out of this mess, it is a debacle which will be with us for the next decade, as the CDO and CDS transactions come to their full term.

“We engaged the piper and we have to pay,” Mr McLernon said.

The upshot is that 2008 and 2009 will go down in history as the Great Deleveraging.

ABN AMRO Newport partner Simon Bond describes it as a global margin call coupled with forced liquidations. “We will continue to see ongoing global deleveraging and many of the hedge funds will be put out of business after living high on a cocktail of leverage, cheap debt and stupendous bonuses,” Mr Bond said.

Welcome to the credit crisis. Former investment banker David Kingston, who now runs private investment group K Capital, says the world’s money supply will shrink as the world’s financial systems start deleveraging.

“Overall, banks around the world will need to deleverage by around 25 per cent. More extreme cases may need to deleverage by 50 per cent,” he said.

The best way to do that is to raise new equity capital or substantially reduce the size of loan portfolios.

Mr Kingston said Australian institutions were more conservatively geared than their counterparts in most other countries so even if they had to deleverage by 10 per cent that would involve a substantial capital raising or contraction of their balance sheets. In aggregate, the big four banks have total asset/loan portfolios on-balance-sheet of about $2 trillion.

“They can deleverage 10 per cent by raising $20 billion in capital, or reduce their loan portfolios,” he said.

He had no doubt there would be substantial loan losses that each of the big four banks had not yet booked, which would affect their leverage position.

He also expected a tug of war between deleveraging and expansionary fiscal and monetary policy and government guarantees of the banks.

This tug of war is already taking place. Last week, Commonwealth Bank made a $2 billion placement, ANZ Bank has raised tier-one capital hybrids, and NAB has announced it will continue to underwrite any shortfall in its dividend reinvestment plan for the next two dividend payments.

At the same time, the Reserve Bank and federal Government have been using expansionary monetary and fiscal policy to keep the economy from falling into recession.

In the past couple of weeks, the Reserve has slashed interest rates by 100 basis points, the Rudd Government has guaranteed bank deposits to avoid a run on banks, it has handed out $10.4 billion in one-off bonuses to stimulate the economy, and it has guaranteed wholesale funding to the financial services sector for the next three years.

The ugly sister in the room, derivatives, will however continue to haunt the banks, regardless of the Rudd Government’s gutsy move last week to slap a government guarantee on Australia’s bank deposits and debt raisings.

The reason is simple: banks have been poor at managing risk and as a result have left themselves exposed to those very instruments that Buffett warned about six years ago.

Worst still, these instruments operate in the murky Over the Counter market, which lacks regulation and a clearing system, and is essentially a secret club.

As Frank Ashe, associate professor of Macquarie University’s Applied Finance Centre said: “The banks keep the OTC market close to their chests. It isn’t as bad in Australia, but the only way banks will trust each other is if they are forced to own up to derivatives and counterparty exposures.”

ANZ and NAB, respectively, have the largest and second largest exposures to credit derivative-related counterparties. NAB’s total notional credit derivative exposure at September 30, 2007, was $24 billion.

ANZ’s total notional value of credit default swaps on its balance sheet at March 31 was $45.7 billion. This consisted of $23.4 billion of credit derivatives purchased and $22.3 billion of credit derivatives sold.

Mr Ashe also said the regulators should enforce some sort of clearing system in the OTC market so somebody was monitoring what was going on. “This is a good time to argue against banks saying there is no problem, because there is nothing to stop it happening here. We can’t trust risk management inside the banks to a high degree, so we want to increase the systemic safety and the OTC is a way to do that,” he said.

“We need more disclosure and we need a central clearing system so we know where the risk ends up,” he said.

To put its size in perspective, the OTC market turned over $79.5 trillion in the year to June 30, 2008, up 0.5 per cent on the previous year after a 14 per cent rise in 2006 compared with $42 trillion for the total exchange-traded markets, which includes the ASX and the Sydney Futures Exchange.

What is frightening about these figures is that the OTC market is also the stomping ground for day traders, hedge funds and other operatives who want to operate under the radar of the less than perfect regulators of the on-market transactions.

It is in the OTC market where most of the share price manipulation happen. It is off-market where most of the exotic products are traded, such as contracts for difference (CFDs), which are estimated to account for more than 15 per cent of the trading volumes in the physical market as they hedge their accounts.

Indeed, Standard & Poor’s New York-based global chief economist David Wyss recently warned that the OTC derivatives market was the next sub-prime bomb in global credit markets.

“The over-the-counter derivatives market is a little scary because we don’t know how big the risks are,” Wyss said during a recent visit to Australia.

Until these risks become known, the markets will continue to falter, according to the president of the US Information Policy Institute political and economic research council, Dr Michael Turner, who visited Australia this week: “The capitalist economy is predicated on trust, and trust is gone. To help rebuild trust there needs to be co-ordinated global action.”

There also needs to be more transparency, and better credit checks to avoid another sub-prime crisis.

Original Article

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