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:
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).
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.