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Today's Market WrapUp 08.13.2007 Mon Tue Wed Thu Fri Kirby Archive Analysis
of the Unfolding OTC Derivatives Melt Down In the past few weeks we’ve all been ‘peppered’ with reports about CDO’s and growing contagion associated with sub-prime mortgages. For clarity’s sake – everyone should first understand that these instruments are – for the most part – all broadly defined as OTC derivatives. What now appears to be ‘systemic problems’ in the Financial System all began with revelations by Bear Stearns. Interestingly, in Bear Stearns latest 10-K filing with the SEC, they self-describe [at the top of page 54 if you want to play along at home] their activities conducted in off-balance-sheet-arrangements are described as follows: In the normal course of business, the Company enters into arrangements with special purpose entities ("SPEs"), also known as variable interest entities ("VIEs"). SPEs are corporations, trusts or partnerships that are established for a limited purpose. SPEs, by their nature, are generally not controlled by their equity owners, as the establishing documents govern all material decisions. The Company's primary involvement with SPEs relates to securitization transactions in which transferred assets, including commercial and residential mortgages, consumer receivables, securities and other financial assets are sold to an SPE and repackaged into securities or similar beneficial interests. SPEs may also be used to create securities with a unique risk profile desired by investors and as a means of intermediating financial risk. The Company, in the normal course of business, may establish SPEs, sell assets to SPEs, underwrite, distribute and make a market in securities or other beneficial interests issued by SPEs, transact derivatives with SPEs, own securities or other beneficial interests, including residuals, in SPEs, and provide liquidity or other guarantees for SPEs. I make mention of the use of SPE’s – where the use of derivatives is concerned – because this term has a familiar “ring” to it. SPE’s were the very same accounting structures which Enron used to hide a quagmire of fraudulent OTC derivatives transactions. As Trinity University’s Bob Jensen pointed out in a paper titled, What's Right What's Wrong With [SPEs], SPVs and VIEs: The Whitewing SPE is only one of the thousands of Special Purpose Entities set up by Enron CFO Andy Fastow with the assistance of its auditor, Andersen, and its law firm. The SPE appears to be almost hopelessly complex to hide risk as well as hide the trail of the millions of dollars Andy Fastow was making in double dealing at Enron. If nothing else, the preceding points out that – at the core - Bear Stearns latest troubles ALL stem from derivatives risk. How Is Derivatives Risk Quantified? Derivatives risk is measured in terms of VaR, a model that gauges how much a bank could lose in a day if markets moved against it. Now let’s take a look at Bear Stearns’ VaR [from page 60 of their 10-K filing]:
So, Bear Stearns - with a current VaR of 28.7 – appears to have lost perhaps as much as 3 billion dollars: On June 22, Bear Stearns investment bank announced that it intended to bail out two of its failing hedge funds, by extending to them between $1.6 to $3.2 billion in emergency loans—the latest twist in Wall Street efforts to prevent a full-blown mortgage securities market crisis. Now, let’s take a look-see at their OTC derivative ‘exposure’ as reported in their latest 10-k [page 63] as of May 31, 2007:
To be honest, I’m still having trouble getting my head around “how” Bear could have lost the amounts being bandied about in the market place – but based on anecdotal reports concerning ratings downgrades of investment grade paper – the bulk of Bear’s problems must be stemming from the AAA, AA, and A segments in the table above. To lose 3 billion on this amount of aggregate business implies a “virtual write-off” of the whole business segment. The One Cock-Roach Rule How many of you have heard the axiom, “If you see a cock-roach, you’ve got cock-roaches?” The difficulties stemming from Bear Stearns has created reverberations throughout global financial markets with difficulties being reported in Australia, France and Germany. But what about other U.S. financial institutions? In the grand scheme of things, Bear Stearns is a “small payer” when it comes to OTC derivatives. If we take a peak at the latest Office of the Comptroller of the Currency’s latest Quarterly Derivatives Report, [page 24] we can see that J.P. Morgan has a derivatives book of some 70+.
TRILLION in notional, Citibank at 30+ TRILLION in notional and B of A at 28+ TRILLION. Logic would dictate, that if Bear Stearns has incurred losses of the magnitude being reported – other BIGGER PLAYERS must be on the hook for much larger amounts. Let’s take a look at Citibank, for instance. Just this past weekend Citibank revealed: Citigroup
seen taking $700 million in credit losses SAN FRANCISCO (MarketWatch) -- Citigroup Inc. has reportedly lost more than $700 million in credit business in recent weeks, placing the world's biggest financial services firm high on the list of casualties from the market-roiling credit crunch. Personally, I’m amazed Citibank got off so light. Let’s take a look at their VaR, [page 5] shall we?
Here, we can see that Citigroup [Citibank] has VaR of $121 compared to Bear Stearns at $28.7, and Bear Stearns lost HOW MUCH? Look for Citibank to be ‘revising’ loss estimates UPWARD in the NEAR FUTURE. Also of major concern: How about B of A and J.P. Morgan Chase? This morning, we learned that none other than Goldman Sachs is “topping up” one of their hedge funds to the tune of, oh, 3 BILLION dollars: Goldman
Sachs hedge fund gets US$3B bailout after big market losses
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Year Ended November |
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| Risk Categories | 2006 | 2005 | 2004 |
| Interest rates | $49 | $ 37 | $ 36 |
| Equity Prices | 72 | 34 | 32 |
| Currency Rates | 21 | 17 | 20 |
| Commodity Prices | 30 | 26 | 20 |
| Diversification effect (2) | (71) | (44) | (41) |
| Total | $101 | $70 | $67 |
| (1) Beginning in the first quarter of 2006, we excluded from our calculation of VaR certain equity positions generally due to their transfer restrictions or illiquidity. The effect of excluding these positions was not material to prior periods and, accordingly, such periods have not been adjusted. For a further discussion of the market risk associated with these positions, see “— Other Market Risk Measures” below. | |||
| (2) Equals the difference between total VaR and the sum of the VaRs for the four risk categories. This effect arises because the four market risk categories are not perfectly correlated. | |||
Conclusion[s]
Losses being reported by Citibank are inconsistent with observable, comparable, already reported data from both Bear Stearns and Goldman Sachs. We have yet to hear from either J.P. Morgan Chase or B of A.
The financial system is, shall we say, fragile. Globally, Central Banks seem intent on bailing out their brethren – as the Prudent Bear’s Martin Hutchinson reported in Helicopter over Wall Street,
Federal Reserve Chairman Ben Bernanke first achieved fame with a November 2002 speech in which he repeated Milton Friedman’s assertion that the Fed could “drop money out of helicopters” if deflation or a credit crunch occurred. The Fed and the European Central Bank now appear to be doing this, having injected $300 billion into the world monetary system in the last two business days. What Bernanke didn’t tell us in 2002 was that his helicopter would hover only over Wall Street.
In the face of this brazen money creation, more than ever, investors should be well served in holding an appropriate percentage of their investment portfolios in both physical precious metals and high quality precious metals producing equities.
Unfortunately, this whole mess is likely to get worse before it gets better.
Today’s Market
Overseas equity markets began the week on a positive note with Japan’s Nikkei Index adding 35 points to 16,800. North American markets ended the day lower with the DOW off 3 to 13,236.50, the NASDAQ down 2.65 to 2,542.24 and the S & P giving up .75 to 1,452.90. NYMEX crude oil futures were up .13 to 71.60 per barrel.
On foreign exchange markets the US Dollar Index gained .38 to 80.97.
Interest rates were 2 – 3 basis points lower across the curve with the benchmark 5 yr. bond ending the day at 4.55% while the 10 yr. bond finished the day at 4.77%.
The precious metals complex ended the day lower with COMEX gold futures falling .60 to 670.30 per ounce while COMEX silver futures dropped .02 to 12.87 per ounce. The XAU Index fell 1.03 to 143.27 and the HUI Index gave up 5.28 to 340.74.
On tap for tomorrow, at 8:30 a.m. July PPI data is due. Headline number expected +.1% vs. prior -.2%. Core expected +.1% vs. prior +.3%. Also at 8:30 a.m., June Trade Balance data is due, expected -61.0 B vs. prior -60.0 B.
Wishing you all calm nerves, successful investing and pleasant August evening!
Rob Kirby
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