When Certainty Isn’t Enough

In a phone conversation today about my recent rhetorical question asking “Who Plays AIG in the Sequel?” I was moved to explain about the problem with a network of counterparties, none of whom is disclosing who they trade with.

It even has a name — Herstatt Risk.  Amazingly enough, Germany’s 35th largest bank (in 1974) had enough unsettled US Dollar – German Deutschmark currency exposure when it was shut down to take down several larger banks.  In a sense, that’s what happened again in 2008, and is somewhat likely to happen this year or next.


When the global economic system froze up after the Lehman collapse, the reason came from “left field” — the oldest and largest institutional Money Market Fund  ($3.5 trillion) broke the buck.  At that moment, we got to peer over the edge of the abyss.

All around the world, central bankers found themselves in the uncomfortable position of putting their taxpayers at risk to guarantee private company credit.  And it wasn’t just banks with their massive exposure to short-term CD rollover risk.  Perhaps more important was the fact that Commercial Paper couldn’t be rolled over, so even companies like Exxon, Disney and GE lost access to their most important source of day-to-day operating cash.

That’s why I’m intrigued by the following chart:

This chart shows the spread between 3-month LIBOR and the Overnight Indexed Swap.  Many call this the measure of the banking system’s “distrust” of each other.

It peaked just under 400 basis points on that fateful weekend after “Lehman Day.”  Here’s an excellent summary and definition of this spread put out by the research team at the St. Louis Fed in late 2008.

Now we are faced with the reality that the market “knows” to a 96% certainty that Greece will default, or at least that’s the estimate embedded in the pricing of Greek CDS.  When was the last time any investor knew about a major discontinuity event in the market ahead of time?

Hint:  Discussion at the time said it was the collapse of Lehman.

People were disgusted at the sweetheart deal that merged Bear Stearns with JP Morgan Chase, putting JPM on the hook for only $1 billion and the US taxpayer at risk of losing $29 billion in the Maiden Lane toxic MBS financing.

The rationale was that the Bear collapse was a surprise that could shock the market, but by the time Lehman went down, everybody had had six months to prepare.


In a matter of days, the collapse of Lehman had led to GE potentially not being able to meet its payrolls or pay its suppliers.

Contagion, writ large.

Let’s hope that the anti-regulation crowd doesn’t keep delaying and preventing us from getting a system that eliminates or mitigates a similar crisis.

They’ve already shown amazing reslience in their strategic retreat, with the latest round of the rear-guard action consisting on ever-lengthening comment periods for derivative disclosure and settlement.

In the mean time, the effort to keep the ability to destroy the world is proceeding on several fronts.  Last night’s Presidential debate showed that every candidate wants to repeal the pathetic attempt to address the systemic weaknesses called “Dodd-Frank.”  Then there’s the bogus “budget” argument that is being used to cut funds for the SEC and the CFTC.  Strangely enough, those budgets don’t come from taxpayer funds, but from fees paid by the banks and Wall Street.  Those fees are set by the budget levels Congress sets for the regulators, so cutting those budgets makes not a penny difference to our deficit.  Every dime of lower SEC budget goes into increased Wall Street profits.

I think the most interesting part of this is that it shows the only time I know of Alan Greenspan admitting he made a fundamental error in policy judgment.  Too bad he didn’t include probability analysis when he decided to shut Brooksley Born down when she warned against the black hole of derivatives contracts.

Any student of probability knows that even if the chances are one in ten thousand of any single event being a disaster, it only takes about seven thousand trials before the aggregate odds of a disaster are above 50%.  Greenspan assumed that every swap counterparty would correctly judge their counterparty’s ability to pay, and protect themselves from failure, every single time.

Welcome to the world that let AIG become the biggest loser in the subprime mortgage bond business, without ever making a subprime mortgage loan.  It was all in the swaps (Credit Default Swaps), and those weren’t even looked at by ANY regulator, thanks to the Commodity Futures Modernization Act.

So now you know.  The market is virtually certain there will be a Greek default.  It just doesn’t know who it will hit, and can’t know.  I guess that will just make life more expensive for everybody until we find out where the bodies are buried, and which of our financial institutions blew their risk calculations (and which of their counterparties can’t survive them falling).

Here’s 30-second slo-mo film you may enjoy.

It took 28 years after Herstatt before the foreign exchange market finally put together the CLS (Continuously Linked Settlement) system to prevent a repeat.  Let’s hope the exotic derivatives over-the-counter swap market risk doesn’t hang out there without a solution that long.



2 Responses to When Certainty Isn’t Enough

  1. Cheery news, indeed, but the spread was that high from mid-May to mid-July last year (http://goo.gl/aiveY), so it’s not immediately obvious why the recent rise presages an order of magnitude jump.

    • hhill51 says:

      True enough. Maybe I should point out that this spread widened to more than 80 basis points after the Bear went down, and that it had only come down nearer the historical single-digit level recently. One thing we do need to notice is how the spread relates to the Fed Funds rate, so that the expense of this uncertainty is relatively more significant post-crisis than it was before ZIRP. I tried to soften the predictive strength of the indicator in my post, but maybe it sounds like I’m saying the warning bell has definitely sounded.
      As I was telling my friend in the phone conversation that prompted this post, the real weirdness is that we could see some regional bank go insolvent by virtue of sponsoring a CP vehicle that ends up needing to exercise its liquidity call by breaking the buck or being unable to roll its CP. By that means, a bank that has absolutely no Greek exposure and only indirect European bank exposure could turn out to be a disaster. Imagine the shock in the heartland if they woke up one day to find out that their local super-regional bank was gone. It’s all the links and potential paths in the network that makes today’s situation so difficult. And no one yet seems willing to say that taxpayer guaranteed obligations like our banks gives us the right to ask who their customers are, and how they are protecting themselves from those customers. Instead, we just get the loss if they blow up.

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