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I suppose this is affected by the fact we don't really know how all this new derivatives-based finance will react when faced with a real crisis?

Un roi sans divertissement est un homme plein de misŤres
by linca (antonin POINT lucas AROBASE gmail.com) on Mon Jun 18th, 2007 at 04:11:10 PM EST
As Rattner says:


Assessing the likely consequences of a correction is more daunting than merely predicting its inevitability. The array of lenders with wounds to lick is likely to be far broader than we might imagine, a result of how widely our increasingly efficient capital markets have spread these loans. No one should be surprised to find his wallet lightened, whether out of retirement savings, an investment pool or even the earnings on their insurance policy.

The bigger -- and harder -- question is whether the correction will trigger the economic equivalent of a multi-car crash, in which the initial losses incur large enough damages to sufficiently slow spending enough to bring on recession, much like what happened during the telecom meltdown a half-dozen years ago.

The thing with derivatives today is that nobody knows where the risk is now, on a macro basis. So we don't know who will be left holding the bag. Maybe it will be nicely spread around so that the financial world absorbs a lot of the pain itself (funds lose out, banks eat their reserves, investors see their portfolio lose value) and there is no need for a bailout. Or there will be more localised breakdowns in places of unexpected concentration of risk, which may threaten to spread and require public intervention. We just don't know.

In the long run, we're all dead. John Maynard Keynes

by Jerome a Paris (etg@eurotrib.com) on Mon Jun 18th, 2007 at 04:34:18 PM EST
[ Parent ]
The problem is not derivatives, it's the over-the-counter market in custom-designed financial products.

Can the last politician to go out the revolving door please turn the lights off?
by Migeru (migeru at eurotrib dot com) on Mon Jun 18th, 2007 at 04:46:12 PM EST
[ Parent ]
Could you elaborate on that?

The fact is that what we're experiencing right now is a top-down disaster. -Paul Krugman
by dvx (dvx.clt št gmail dotcom) on Mon Jun 18th, 2007 at 05:05:44 PM EST
[ Parent ]
There are two kind of financial products: exchange-traded and over-the counter.

Exchange-traded products are standarised and to some extent trackable (at least in terms of volume outstanding and traded, etc) because of regulatory requirements and those of the exchange itself. Banks provide bespoke financial products to their customers "over the counter", with very limited regulatory oversight or reporting requirements. Financial derivatives and "swaps" can be (and are) used to circumvent regulatory limits, hide transactions and holdings, reduce one's tax base, etc.

I'm suggesting that, if there were no OTC market it would be less difficult (in principle) to have an idea of where the risk is.

On the other hand, it's in the OTC market where "financial innovation" takes place.

Can the last politician to go out the revolving door please turn the lights off?

by Migeru (migeru at eurotrib dot com) on Mon Jun 18th, 2007 at 05:14:04 PM EST
[ Parent ]
You don't need complex derivatives to blow yourself up.

Some hedge funds are taking huge positions on listed derivative markets. It's just that when they fail through listed markets the boom is spread a bit to the clearing exchange members and it happens earlier through margin calls.

Whereas in the OTC market you have only one counterparty that takes the boom (or a chain of counterparties).

AFAIK, there is no more regulatory reporting requirement in OTC than in listed.

Banks are supposed to monitor their risk and regulators supposed to monitor banks risk monitoring. If a bank blows up, the boom goes to in order:

  1. shareholders
  2. bondholders
  3. deposits of clients in the bank

Part 3 is you and me money. Did you get a dividend for the risk you're taking? :)
by Laurent GUERBY on Mon Jun 18th, 2007 at 05:35:55 PM EST
[ Parent ]
AFAIK, there is no more regulatory reporting requirement in OTC than in listed.

Do you mean no less regulatory requirement?

Can the last politician to go out the revolving door please turn the lights off?

by Migeru (migeru at eurotrib dot com) on Mon Jun 18th, 2007 at 05:39:00 PM EST
[ Parent ]
I mean it's the same reporting requirement.

OTC requirement = listed requirement.

by Laurent GUERBY on Mon Jun 18th, 2007 at 05:44:08 PM EST
[ Parent ]
I don't agree: some mortage CDO's, corporate index CDS, tranches thereof, and all sort of other MBS are all listed stuff with delirial risks. And they will be among the first hit by the subprime meltdown. And the amounts at stakes are openly known, and they are already frightening.

I dont' mean the OTC are not another (possibly bigger) time bomb, I mean it is possible to blow up the planet by taking risk on listed stuff alone, and it has already been done, that listed bomb is cocked ready to set off.

I've seen some CDS on baskets of corporate lenders in europe which, according to some basic industry-standad default event models (thoroughly untested outside of the highly benevolent period of low refinancing rates), have their price go from zero to full pay for changes of just 1 bp at a certain threshold value of the borrower's spread. These threshold values are just a percentage point away from the present rates.

If the corresponding (listed) CDO really fares like the model suggest (symmetric of its default swap), this is going to be ugly, and it will happen, not overnight, but in just weeks as bankruptcies pile up.

Pierre

by Pierre on Tue Jun 19th, 2007 at 10:26:44 AM EST
[ Parent ]
http://europa.eu/eur-lex/en/treaties/dat/EU_treaty.html


CHAPTER II

OBJECTIVES AND TASKS OF THE ESCB

Article 2

Objectives

In accordance with Article 105(1) of this Treaty, the primary objective of the ESCB shall be to maintain price stability. Without prejudice to the objective of price stability, it shall support the general economic policies in the Community with a view to contributing to the achievement of the objectives of the Community as laid down in Article 2 of this Treaty. The ESCB shall act in accordance with the principle of an open market economy with free competition, favouring an efficient allocation of resources, and in compliance with the principles set out in Article 3a of this Treaty.

Article 3

Tasks

3.1. In accordance with Article 105(2) of this Treaty, the basic tasks to be carried out through the ESCB shall be:

  •  to define and implement the monetary policy of the Community;

  •  to conduct foreign exchange operations consistent with the provisions of Article 109 of this Treaty;

  •  to hold and manage the official foreign reserves of the Member States;

  • to promote the smooth operation of payment systems.

[...]

Article 19

Minimum reserves

19.1. Subject to Article 2, the ECB may require credit institutions established in Member States to hold minimum reserves on accounts with the ECB and national central banks in pursuance of monetary policy objectives. Regulations concerning the calculation and determination of the required minimum reserves may be established by the Governing Council. In cases of non-compliance the ECB shall be entitled to levy penalty interest and to impose other sanctions with comparable effect.

[...]
Article 34

Legal acts

34.1. In accordance with Article 108a of this Treaty, the ECB shall:

-  make regulations to the extent necessary to implement the tasks defined in Article 3.1, first indent, Articles 19.1, 22 or 25.2 and in cases which shall be laid down in the acts of the Council referred to in Article 42;

ECB governors are fully and the only ones responsible for what's going on in the credit and financial world.

If they prefer to spend their time and public credit on <i<work market deregulation</i> which is not in their mission instead of their real mission that's really bad, but nobody seems to notice up to know so we'll have to wait for the boom.

And I know who I'll blame then.

by Laurent GUERBY on Mon Jun 18th, 2007 at 05:15:33 PM EST
[ Parent ]

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