by Moshe Silver — author of Fixing A Broken Wall Street
Slouching Towards Wall Street… Notes for the Week Ending Friday, 29 July 2011
Our rising star analyst Rory Green was boning up on advanced economic theory on his way home on Metro North the other night. The conductor came by and, glancing down, saw the title of the book. As he punched Rory’s ticket he muttered, “Send Geithner a copy!”
By the time you read this Screed, the world as we know it may have come to an end. Or, depending on your perspective, the world as we know it has long since ceased to exist and we have spent untold years blundering through a twilit world wreathed in a swirling mist of timelessness and oblivion. Whether you agree or disagree with political positions — whether you adhere to one or another school of economic thought — indeed, even if, like Secretary Geithner, you make a point of stating that you are not an economist — it can be lost on very few that there has been a generational failure of leadership in this nation.
We say “lost on very few,” because there is a group in Washington who believe they are providing this country with strong leadership. This “leadership,” from the Pea-Eater-In-Chief down to the tiniest Tea Partier, has as its primary activity the ennobling of Peevishness with the name of Statecraft. There is no longer One America. Instead, there are many Wrong Americas — Bizzarro Worlds, for readers of the old Superman comics, where flawed simulacra of policy take root. In the eyes of the newly self-appointed guardians of the American Way of Wealth, these ill-conceived policies have spawned freakish social programs that protect people’s jobs, provide education and health care, and feed folks who can not find work. Somewhere along the line our leadership has forgotten its duty is to the people. The crux of our democracy lies not in handing control to the ones who grab the votes (as Stalin said: those who cast the votes control nothing — those who count the votes control everything). It lies rather in protecting the rights of the weak.
Last week we bemoaned Washington’s palpable lack of any sense of stewardship for this once-great nation. Predictably, things are no better as of this writing — though by the time you read these words some clarity may have emerged. People used to speak about the greatness of America. In the early days of the financial crisis people were heard to caution that, over the long haul, no one ever made money betting against America. Now it looks like both sides are rushing to be the first to throw this championship bout, and the bets are out in size (CNNMoney, 26 July, “Betting $4.8 Billion On A U.S. Default.”) Following the prophetic trope that every generation gets the legislators it deserves, we must surely all be very wicked indeed.
Here at Hedgeye we are believers in the phenomenon of Mean Reversion. The reversion to mean of this pathetic political process is that a deal will be struck at the eleventh hour and fifty-ninth minute. It will be a deal that will allow everyone to say they had to give in because all the other folks in the room were so Unreasonable. Everyone will take credit for the parts of the deal that their constituents like, while blaming the rest on everyone else — or on the president, better yet. To put Mean Reversion into the context of social behavior we wish to quote an old college acquaintance, a brilliant harpsichordist who successfully pursued a double major in mediaeval intellectual history and LSD. We always knew he had reached the most mellow stretch of his acid trip when he lapsed into a gentle smile and, as he watched the lives of his fellow students teeming around him, repeated over and over again, “You know… people do what they do all the time, all the time.”
The Depository Trust and Clearing Corporation (DTC) reports that there are $4.8 billion of US CDS on its books — meaning that, in the event of a default by this nation, the banks that have issued these CDS will have to pay out $4.8 billion to the investors who have bought protection. Following last week’s Screed, we note that not all swaps and contracts are held at DTC, so the actual bets out there may be far greater. We shall only have a notion of the magnitude in the event of an actual meltdown. You may want to pack a sandwich.
The CNNMoney article raises a further interesting point. If the US stops paying out on its current Treasurys outstanding — investors own over $9 trillion worth worldwide — the investors who bought credit default swaps will contact the banks on the other side of the trade and demand their money. Enter ISDA — the International Swaps and Derivatives Association — a private club made up of none other than the banks who issue CDS. When Moody’s downgraded Greece’s credit last week — to Ca, one notch above what Mood’s formally calls default — they said the bailout package, entailing “substantial losses” for private investors makes default “virtually certain.”
But wait, says ISDA. The ratings agencies may be able to determine a nation’s creditworthiness, but they don’t get to say when a country goes into default. ISDA governs global trading in credit default swaps. To the extent that anyone keeps tabs on this market, it would be ISDA. One of the reasons the credit crisis of led the world’s financial markets to the brink of utter destruction was the lack of transparency and accountability — areas where ISDA was no more effective than Congress, the CFTC or the SEC. CDS issuers were able to sell the same “protection” to a practically endless list of buyers — with the result that no one ended up actually being protected. The CDS issuers proceeded on a model that was the precise inverse of traditional insurance underwriters. Insurance companies are able to offer protection because, as the pool of insured persons increases, the statistical likelihood of a payout per insured person declines. CDS issuers wrote multiple protective swaps covering the same risk, and even the practice of daisy-chaining their risk back to other swap writers could not prevent one loss from triggering multiple payment obligations, as those re-insurance type layoffs merely created successive pockets of identical risk, but with no more protection at each level. The equivalent would be an insurance company that issues a life insurance policy on the same person every time a new customer signs up. Then, when John Doe passes on, every policy holder receives the entire death benefit. An insurance company that did that would be out of business on the very first claim. Guess what? That’s what happened to Wall Street and the banks.
How does ISDA help prevent this from happening again? Though they have come out with a clear statement, we believe this will prove a knotty question that cloaks the potential for another series of roils to the world’s finances.
ISDA is a federation of swaps and derivatives dealers. They have 850 member institutions in 57 countries including, according to ISDA’s own literature, “most of the world’s major institutions that deal in privately negotiated derivatives…” In fact, about 90 percent of contracts underlying privately negotiated swap or derivative contracts are ISDA contracts, which means they clearly dominate the global business. ISDA has set, and continues to govern, the standards according to which swap transactions are effected, including the trigger, known as a “credit event,” under which credit default swaps must be paid out to their buyers.
ISDA’s 2011 Margin Survey finds that 96 percent of contracts worldwide are subject to some kind of collateralization. But lest you get your hopes up, actual collateral represents a small percentage of a contract’s notional — or payoff value. The ISDA report says “the estimated amount of Collateral in circulation in the OTC derivatives market at the end of 2010 was approximately $2.9 trillion.” The majority of collateral — about 83 percent — was reported by the 14 largest dealers in the survey. These banks are known in the trade as the “G14” — the fourteen largest global dealers: BofA-Merrill Lynch, Barclays, BNP Paribas, Citi, Credit Suisse, Deutsche Bank, Goldman Sachs, HSBC, JP Morgan, Morgan Stanley, RBS, SoGen, UBS, and Wells Fargo. ISDA’s 2010 mid-year survey set the notional amount of interest rate, credit and equity derivative contracts outstanding at $466.8 trillion. Of this, $26.3 trillion was in credit default swaps. Where is the protection on uncollateralized CDS? Well may you ask. The Gang of 14 is hogging the market, which bodes poorly for IDA’s 836 other member institutions.
It turns out the last line of defense is ISDA itself. When Moody’s downgraded Greece last week, ISDA said the downgrade — to the lowest rung of junk status — does not qualify as a credit event. How big a deal is this? As pointed out by our paranoid pals at ZeroHedge (18 June, “Debunking Some Myths About The ‘Greek CDS Contagion’ Threat”) the net daily notional exposure on Greek CDS is a bit over $5 billion. (Food for thought: as of this writing, it is slightly less than total US CDS outstanding.) Greece ranks 21st on the list of notional CDS outstanding by nation, and ZeroHedge thinks the banks are overstating Greek default risk to shake down their counterparties for more margin, as Greek CDS exposure has declined the most among the 30 largest positions over the past year. (The US has seen notional CDS exposure increase 136% in the same period, bringing us to the 26th spot on the table.)
ISDA has laid down the law about determining when credit events arise. But there are holders of CDS who may not want to wait around. Or who, like us, may believe ISDA’s stance is indefensible pandering to the Gang of 14. An organization that represents dealers can be expected to side with them. ISDA says they also represent a substantial number of end users and legitimate hedgers, but a large number of end use contracts are structured through those same dealers. We leave you to form your own conclusion on that score. We have no idea whether anyone is preparing legal action, but the Gang of 14 are carrying some $77 billion in notional exposure. We bet they have long since mobilized their lawyers.
Any legal battle would be between a substantial holder of CDS and a major issuer — a multi billion-dollar hedge fund would contact a major global bank demanding payment in the billions of dollars, being the notional value of the Greek CDS the bank issued to the fund. The legal battle will come down to who defines Default. The fact that ISDA says a Moody’s downgrade is not a credit event will not prevent this matter being decided in the courts. If such an action is brought, it could freeze the global CDS market. We do not know what this would augur for the banks’ balance sheets, but we merely wish to observe that, when the US decided not to bail out Lehman, they failed to take into account the subtle differences between US and UK bankruptcy law. Billions of dollars of hedge fund assets were frozen as the UK courts ploughed through the implications of a Lehman shut-down. This is the famous Law of Unintended Consequences — or, as our college classmate observed, “people do what they do all the time, all the time.”
Our friends in Washington — having whom we need no enemies — are completely missing the hard edge of the implication of a US downgrade. Forget an actual default. Once the first court case has been launched to collect on Greek CDS (or Italian, or Spanish, or Irish) the holders of US CDS will line up at the courthouse door. There will be Dodd-Frankenstinian wrangling in Congress as legislators and the FDIC seek to impose massive new capital requirements on the banks. Further, our elected officials need to look to the ratings agencies for their own performance grades.
Congress appears to like a deal that fails to increase revenues, and puts off any real decision until after the next presidential election. America deserves a heck of a lot better than that. The US has already been placed on Credit Watch by S&P and Moody’s, and a downgrade to AA, while not a default, could turn out to be the tip of a particularly nasty iceberg. Further, if there is a downgrade to AA, it won’t be the last. Ratings agencies — like politicians and disastrously declining markets — do what they do all the time, all the time. Holder of US CDS will likely continue to hold tight as they await the first of several lawsuits over Greek CDS.
Successful hedge fund managers share two characteristics: they are highly intelligent, and they are highly aggressive. We don’t know which major hedge fund is going to be first to sue when a rating agency uses the “D-word,” but we can tell you which ones don’t want to be last: all of them.
This is one possible crack in the half-quadrillion dollar global derivatives market (we love writing those big numbers). There also lurks the possibility that Dodd-Frankenstein will require more than $200 billion in derivatives business to be taken onto the books of the G14 for clearing, meaning they may have to double their capital reserves for these contracts (currently only about half of all OTC derivatives contracts are centrally cleared). Whatever deal they ultimately strike, the banks will certainly double heir exposure if the move to full clearing is implemented. The BIS has analyzed the possible implications of full Dodd-Frankenstein implementation and says the G14 banks could experience “a cash shortfall in very volatile markets” and that the increase in daily margins — automatic in volatile markets — will trigger requirements “for several billions of dollars to be paid within the day.” The BIS estimates that volatility-caused margin calls could eat up 13% of the G14’s cash on hand. If we throw in the likelihood of having to pay out on the US’ own CDS, things begin to get truly interesting.
The Financial Times (27 July, “US Downgrade”) quotes the US Constitution, saying “The validity of the public debt of the United States shall not be questioned.” We read this as a Caesar’s Wife directive: it is not enough that the US government continues to pay its bills. At all times, the world must perceive the US government as financially strong enough to always pay its bills, and as morally upright enough that the nation’s intent should never waver. We are not aware that anyone has suggested that putting off debate until after the next election is unconstitutional (an argument we would readily accept), but down-the-road-can-kicking has become a staple of our fiscal policy. This should, in itself, be reason for investors to take caution when contemplating their exposure in US-backed paper and may be sufficient for a ratings downgrade even if there is a deal.
The current “crisis” is not merely artificial, it has been purposely engineered by those in Washington who are eager to show what immoral creeps their opponents are. Underlying this manufactured crisis is a clear disdain for the principles that made America a great nation. What is really going on here is a multi-pronged effort to undo the foundational principles of America and reshape this nation in the image of some new Rough Beast, variously defined by which group hates which other group more. The debates around whether billionaires should pay more in taxes, or whether payroll taxes are a drag on job creation are all misdirection. What they mask is a society that has become more dangerously divided than at any time in our modern history. Fiscal stability rests on social consensus. Social consensus emerges from a process that recognizes that minorities and the weak must be offered basic protection, a process that elicits the consent of the governed, even when the government is of an opposing party or philosophy. Social consensus arises when people who are clearly different from the majority are nonetheless made to feel fully enfranchised as part of the blended polity that is our nation. The Pew Research Center has just issued a report (26 July, “Wealth Gaps Rise To Record Highs Between Whites, Blacks and Hispanics”) that indicates how dangerously fragmented our nation is becoming. Using government figures through 2009, the last full year for which statistics are available, Pew reports that “from 2005 to 2009, inflation-adjusted median wealth fell by 66% among Hispanic households and 53% among black households, compared with just 16% among white households.” Median net worth for Hispanic households as of 2009 was found to be $6,325; among black households it was $5,677. For whites it was $113,149.
Here’s another comparison. The Wall Street Journal (28 July, Opinion, “The Road To A Downgrade”) complains that spending on social programs has gotten so out of control that a downgrade is all but inevitable. Tracking the Great Society programs of the Johnson years, the Journal, using Heritage Foundation data, editorializes that “last year, the panoply of welfare programs spent about $20,000 for every man, woman and child in poverty.” Another calculation — one which the Journal does not bring by way of comparison — is to line up another federal program against the population it was targeted to serve. The $700 billion in TARP funds was allocated to the banking sector which, according to the Bureau of Labor Statistics, employs fewer than 2.5 million people nation wide, including investment banking personnel. A traditional Wall Street “quick and dirty” analysis shows that, with a population of 2.5 million, TARP alone represents spending of $28,000 per financial sector employee. One might say that Wall Street was merely evening up the game, though we hasten to point out that most of those who benefitted from TARP were closer to the $113,149 median net worth figure than to $5,677.
If you bother to look past the haze of self-generated fecal vapors wafting out of Washington you see that a ratings downgrade is the least of this nation’s worries. Masters of misdirection, our elected officials need more than a textbook on economic theory to set this country back on course.
Going back to that Metro North conductor, some folks stick to what they are good at. This makes the trains run on time. Others rise to their level of incompetence, as popularized in the 1969 management classic, The Peter Principle: Why Things Always Go Wrong. These days everyone expects to be promoted, regardless of their accomplishment at more basic levels. It is no longer about performance; it’s about money. Our society is utterly in thrall to money, and the making of more money than others is not merely the sole measure of competence, but a measure of one’s moral standing. Where folks used to consider it unfair that there is poverty in the world, they now consider it unfair that the poor need to be cared for and seek to undo the very fabric of this nation in the name of quarterly profit reports. We have become a nation of self-seeking extremists: Democratic excesses create Frankenstinian social programs leading, in their worst excesses, to a raging sense of entitlement. Republicans are convinced that are purposely, defiantly impecunious and seek to impose Darwinian rigor across the board.
Our bet: by the time you read this, there will be a deal. Politicians always come together at the last minute to keep their jobs. It’s what they do… all the time. The principal players will be grimacing about what hypocrites their opponents are, but the giant self-created shake-up of the past weeks will have achieved its goal, which is to distract Americans from the deep problems roiling our society. It’s been a great time for the media — with all the fear out there ratings are soaring. It’s been a great pre-election campaign opportunity for politicians to flog their wares before the electorate on national television. And for your Humble Scrivener, it has been yet another affirmation of the sad and oft-learned lesson: if you truly want to understand human behavior, you may find LSD more useful than philosophy.
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