Bad news just gets worse...not only do we have the collapse of the paper credit market.... can you say junk bond scandal of the eighties.. now we have a flashback to bank scandals of the nineties...wait a minute shouldn't the market have regulated itself so this didn't happen, again...once again the myth of self regulation is exposed for the sham it is...global markets are not self regulating never have been that is why Capitalism created the State in its own image.
French bank hit by worst scandal everSocGen trader's $7.1B loss dwarfs Barings debacle
PARIS - A junior computer whiz at the French bank Societe Generale has been accused of racking up a $7-billion loss in bad bets on stocks in the biggest trading scandal in banking history.
France's central bank and government scrambled to shore up confidence in the banking system after the 144-year-old SocGen told investors already battered by the credit crisis that it had discovered the "exceptional" fraud late last week.
The trader had circumvented the bank's risk controls through in-depth knowledge of its computer systems, but was caught when he tried to cover up his losses.
The country's central bank chief dubbed the trader "a genius of fraud" while French police announced a criminal probe.
Richard Fuld, the chief of Wall Street firm Lehman Brothers, called the debacle "everyone's worst nightmare" at the meeting of policy and business leaders in Davos.
The losses spiralled to ¤4.9-billion ($7.1-billion) -- nearly its net profit in 2006 -- as the bank tried to close out the rogue trader's stock index futures positions in Monday's sliding market.
2002: Former currency trader John Rusnak accused of hiding US$691 million in losses at Allfirst bank of Baltimore, at the time under parent Allied Irish Bank, pleads guilty to one of the largest bank fraud cases in U.S. history. Rusnak was sentenced in 2003 to 7 1/2 years in prison._ 1996: Sumitomo Corp., a 300-year old Japanese metals trader, discovers that its star copper trader, Yasuo Hamanaka, amassed $2.6 billion in losses in unauthorized trades over a decade. The revelation caused copper prices to plummet worldwide. Sumitomo has paid millions of dollars in class action lawsuits and Hamanaka served more than seven years in prison.
_ 1995: Collapse of Britain's Barings Bank after a trader in Singapore, Nick Leeson, lost 860 million pounds (then worth US$1.38 billion) on futures trades. The fraud prompted banks worldwide to tighten internal checks. Leeson spent four years in prison.
_ 1995: Toshihide Iguchi, a New York bond trader for Japan's Daiwa Bank, charged with hiding $1.1 billion in trading losses he accumulated over 12 years. The bank later pleaded guilty to failing to notify U.S. authorities sooner. It was hit with $340 million in fines and ordered to shut its U.S. operations. Iguchi was sentenced to four years in prison and fined.
1994: Joseph Jett, a government bond trader at Wall Street brokerage Kidder Peabody & Co., was fired after the firm accused him of faking $348 million in profits to fatten his bonus. Jett denied wrongdoing and wasn't charged criminally. Last year a federal judge upheld a March 2004 order by the Securities and Exchange Commission saying Jett had booked fake profits of approximately $264 million and had to return $8.2 million of bonuses and pay a $200,000 civil penalty. The scandal contributed to the demise of the venerable Kidder.
_ 1991: Bank of Credit and Commerce International (BCCI), operating in nearly 70 countries, is seized by bank regulators, acting on auditors' reports of huge losses from illegal loans to corporate insiders and from trading transactions. Some 250,000 depositors left without funds. Claims exceeded US$10 billion.
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Bank of America Settles Suit Over the Collapse of Enron - WSJ.com By Rick Brooks and Carrick Mollenkamp Staff Reporters of THE WALL STREET JOURNAL
Companies Featured in This Article: Bank of America, Citigroup, J.P. Morgan Chase, Merrill Lynch, Deutsche Bank, Canadian Imperial Bank of Commerce, Toronto-Dominion Bank
Bank of America Corp. became the first bank to settle a class-action lawsuit alleging that some of the top U.S. financial institutions participated in a scheme with Enron Corp. executives to deceive shareholders.
The Charlotte, N.C., bank, the third-largest in the U.S. in assets, agreed to pay $69 million to investors who had billions of dollars in losses as a result of Enron's collapse amid scandal in 2001. In making the settlement, Bank of America denied that it "violated any law," adding that it decided to make the payment "solely to eliminate the uncertainties, expense andWhy the Blowup May Get WorseNot since 1966 -- when the term "credit crunch" was coined after the Fed pushed market interest rates above the legal limits banks and thrifts then could pay on deposits and thus stopped lending in its tracks -- has the nation's mortgage apparatus been so close to breaking down.
The current crisis arguably has the potential for more economic disruption than the celebrated 1998 Long Term Capital Management meltdown. Then, as Northern Trust economist Asha Bangalore points out, the economy cruising along -- in contrast to the past four quarters, which have seen below-potential growth on average.
Moreover, mortgage borrowers perversely benefited from the LTCM fiasco. Not only did the Greenspan Fed lower rates, sparking a huge bond rally, but, also, the government-sponsored enterprises Fannie Mae (FNM) and Freddie Mac (FRE) went on virtual buying sprees. As a result, the biggest part of the credit market -- mortgages -- remained flush. Now, Fannie is looking to expand its portfolio beyond the $727 billion limit imposed on it after its accounting and governance scandals -- a move viewed skeptically by the White House but supported by some congressional Democrats.
Indeed, the full impact of the mortgage crisis still lies ahead. From the beginning of 2007 through mid 2008, interest rates on over $1 trillion of adjustable-rate mortgages are slated to be reset, many from low "teaser" rates.
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THE SUBPRIME MESS ALSO RECALLS another crisis -- the virtual collapse of the commercial-paper market in the wake of the Penn Central bankruptcy of 1970. Back then, the paper market consisted of relatively simple short-term corporate IOUs. Now, so-called asset-backed commercial paper is backed by all manner of things, from credit cards and auto loans to collateralized debt obligations, and comprises over half the CP outstanding. Moreover, notes MacroMavens' Stephanie Pomboy, money-market funds own 27% of CP outstanding.
While the Fed managed to soothe the financial markets' nerves by week's end, the potential for future upheavals remains. As a result, the futures market is looking for the central bank to ride to the rescue with rate cuts. Fed-funds contracts are fully discounting a quarter-point cut, to 5%, at the Sept. 18 Federal Open Market Committee meeting, and a further reduction to 4¾% in December.
As the chart here shows, financial crises have tended to coincide with peaks in the fed-funds rate and subsequent Fed easing. The subsequent rate relief would be hailed by the markets as the start of a new bull run.
There is a new wrinkle -- the precarious state of the dollar. No longer is the greenback viewed as a safe haven in the world, contends Barclay Capital's currency team.
Indeed, as MacroMavens' Pomboy has posited, a Fed rate cut that sends the dollar tumbling could have a perverse effect. The influx of foreign capital has kept U.S. interest rates low and provided a flood of credit for everything from leveraged buyouts to, of course, subprime mortgages. If there's an exodus of foreign capital fleeing a declining dollar, credit could tighten even as the Fed eases. Be careful of what you wish for.
High-yield debt - Wikipedia, the free encyclopediaThe original speculative grade bonds were bonds that once had been investment grade at time of issue, but where the credit rating of the issuer had slipped and the possibility of default increased significantly. These bonds are called "Fallen Angels".
The investment banker, Michael Milken, realised that fallen angels had regularly been valued less than what they were worth. His time with speculative grade bonds started with his investment in these. Only later did he and other investment bankers at Drexel Burnham Lambert, followed by those of competing firms, begin organising the issue of bonds that were speculative grade from the start. Speculative grade bonds thus became ubiquitous in the 1980s as a financing mechanism in mergers and acquisitions. In a leveraged buyout (LBO) an acquirer would issue speculative grade bonds to help pay for an acquisition and then use the target's cash flow to help pay the debt over time.
In 2005, over 80% of the principal amount of high yield debt issued by U.S. companies went toward corporate purposes rather than acquisitions or buyouts.
High-yield bonds can also be repackaged into collateralized debt obligations (CDO), thereby raising the credit rating of the senior tranches above the rating of the original debt. The senior tranches of high-yield CDOs can thus meet the minimum credit rating requirements of pension funds and other institutional investors despite the significant risk in the original high-yield debt.
Hedge funds have gotten rich from credit derivatives. Will they blow up?| From: | "Kevin McKern" |
| Received: | 10/19/2006 11:45 AM |
| Subject: | Will they blow up? |
The downfall of Amaranth Advisors, the hedge fund that lost $6 billion in a single week by betting on natural gas, was a special case. There was no domino effect taking down energy traders generally, no meltdown of an industry. But if you want to fret over the next financial catastrophes, turn your gaze away from energy futures and focus on something far more obscure: credit default swaps. Hedge funds are neck-deep in these derivatives, and if something goes wrong, the pain will be widespread. A credit swap is an insurance policy on a bond, often a junk bond. The fellow selling the swap--writing the policy, that is--collects a premium. If nothing goes wrong, he pockets the premium and looks like a financial genius. But if the bond defaults, the swap seller has to make good. The notional amount--the aggregate of bonds, loans and other debt covered by credit default swaps--is now $26 trillion. This is a staggering sum, twice the annual economic output of the U.S. Hedge funds account for 58% of the trading in these derivatives, says Greenwich Associates, a financial research firm. Selling protection has been a big moneymaker for funds like $23 billion (assets) D.E. Shaw and $12 billion Citadel, say market participants, and for specialized outfits like Primus Guaranty (nyse: PRS - news - people ) in Bermuda, which took in $57 million in the first half of 2006 selling protection on $1.6 billion in debt. With corporate debt defaults low these days, the temptation is high to write insurance policies on bonds. A hedge fund can make $60,000 to $1 million a year selling protection on $10 million in bonds. It's like finding money in the street. Unless, of course, the economy suddenly enters a recession. If that happens, hedge funds addicted to the credit market will be in deep trouble. "A lot of [hedge funds] have sold insurance, are sitting on the premiums--and are bare-ass," says Charles Gradante, cofounder of Hennessee Group, which tracks hedge fund performance. "If there is a Long Term Capital-type systemic risk potential out there, it's in the [credit swap] market." There must be a lot of investors--or credit speculators--who are cavalier about corporate defaults because junk bonds are trading at yields only modestly higher than the yields on safe U.S. Treasury bonds. The chart displays the yield spread, as calculated by Moody's Investors Service, between junk bonds rated speculative and seven-year Treasurys. Saks bonds with a 97TK8 coupon due October 2011, for example, are now yielding 7.6%, or 287 basis points (2.9 percentage points) over seven-year Treasurys, compared with a 700-basis-point spread to Treasurys four years ago. Today's tight spreads don't leave much of a cushion to cover defaults. There is a close correlation between yield spreads and credit default swap prices. That's because selling a credit swap is equivalent to buying the corporate bond on margin. If you buy a junk bond with borrowed funds, you collect the high coupon on the bond while paying out a lower amount, presumably not too much more than what the U.S. government pays to borrow money. Either way--with a swap or a margined bond trade--you pocket the spread, unless and until the corporate bond gets into trouble, at which point you're sitting on a painful capital loss. The credit-derivatives business is dominated by 14 dealers. Among them: jpmorgan Chase, Citigroup (nyse: C - news - people ), Bank of America (nyse: BAC - news - people ), Goldman Sachs (nyse: GS - news - people ) and Morgan Stanley (nyse: MS - news - people ). All have staggering amounts of derivatives on their books: JPMorgan's notional exposure was $3.6 trillion as of June 30, according to the Federal Deposit Insurance Corp., which is almost three times assets and 30 times capital. Credit derivatives at Wachovia Corp. (nyse: WB - news - people ) have jumped sevenfold since 2003 to $170 billion, more than three times capital. Banks love derivatives because they provide multiple ways to make money. Revenue from all types of derivatives will hit $34 billion or so this year at U.S. banks and securities firms, says Tower Group (nasdaq: TWGP - news - people ), a financial-research outfit, with hedge funds generating much of the money. Hedge funds also buy the potentially toxic waste that banks create when they bundle credit derivatives into so-called synthetic deals. By separating a portfolio of derivatives into different tranches, banks can create virtually default-proof securities for conservative investors--if somebody else is willing to buy riskier "equity" tranches whose value vaporizes when as few as one or two of the underlying bonds default. Banks once kept such tranches on their books as a cost of doing business. Now, says Fitch Ratings, hedge funds are buying them to goose returns. Regulators say there's no reason to worry--yet. All big banks require hedge funds to back up their swaps with cash collateral that is adjusted daily, says Kathryn Dick, deputy comptroller for credit and market risk at the Office of the Comptroller of the Currency. But banks can make only rough guesses at the value of swaps and thus how much collateral their counterparties need to ante up. Even the smartest guys can come up shorthanded. Ask Charlie T. Munger, vice chairman of Warren Buffett's Berkshire Hathaway (nyse: BRKA - news - people ), which lost $404 million unwinding credit, interest-rate and foreign-exchange derivatives positions in its General Re unit. "When we ran it off, it didn't run off at anything like book value," Munger says. "I would bet a lot of money there are some terrible valuations on the books of corporate America." JPMorgan, the most forthcoming of the big derivatives dealers, figures it could lose $65 billion over several years if everybody on the other side of a derivatives trade went broke. A scary number when compared with the bank's $110 billion in capital. Implausible, too, because most of its counterparties are big financial institutions. Hedge funds and other smaller players are much more exposed. Like swaps on interest rates and foreign currency, credit swaps outstanding dwarf the underlying bonds in circulation. That can be a problem when a creditor defaults, as with Delphi (nyse: DPH - news - people ) and other auto parts makers earlier this year. With most swaps, the buyer of protection has to hand over defaulted bonds to get its money, tough to do if, as with Delphi, $20 billion in protection has been written on just $2 billion in bonds. Calamity was averted by the International Swaps & Derivatives Association, which held an auction to determine the amount of cash protection buyers would get. The derivatives market weathered its last near-death experience in early 2005, when credit agencies downgraded the debt of General Motors (nyse: GM - news - people ) and Ford (nyse: F - news - people ), devastating the value of the most risky synthetic derivatives. Hedge funds thought they'd been smart by locking in a three-to-four-percentage-point spread by selling protection on those tranches and buying it on less risky ones. Suddenly, though, they had to close out their moneylosing positions. So many funds had made the same bet that it "magnified the deleveraging process," in the dry words of the Bank for International Settlements. Translation: "Banks refused to buy or sell," says Randall Dodd, a former Commodity Futures Trading Commission economist who now runs the Financial Policy Forum, a Washington think tank. "These guys couldn't trade out of their positions." Bottom-fishing investment banks eventually bailed hedge funds out of their problems. But Dodd and other critics wonder if banks have extracted enough collateral from their hedge fund clients to protect themselves in a wider crisis. "No one has good facts on these things," says David Hsieh, professor at Fuqua School of Business at Duke University, "because hedge funds are private investments."
Balancing the Books
A Legacy Worth Disinheriting: The Federal Reserve remains spooked by the specter of the Great Depression
Edited by Jay Palmer
03/03/2003
Barron's
32
A History of the Federal Reserve Volume 1: 1913-1951
By Allan H. Meltzer
University of Chicago Press; 800pp; $75
Reviewed by Randall W. Forsyth
Central bankers, like generals, often are accused of fighting the last war. The Federal Reserve remains haunted by its most humiliating defeat -- an utter failure not only to prevent the Great Depression, but its ineptitude in countering the most severe downward spiral in American economic history. That failure arguably has a profound impact on Fed policy to this day.
Serious students of monetary policy will be familiar with the broad outline of what's told in Allan H. Meltzer's monumental "A History of the Federal Reserve: Volume 1: 1913-1951." The Great Depression is the most crucial period covered in the book, which encompasses the span from the Fed's founding to the Treasury Accord of 1951, when it gained its independence as a modern central bank.
Unlike others who lay the blame for the Depression on a single cause -- the stock-market Crash of '29, the Smoot-Hawley tariff, the collapse of the international gold standard or the Fed's permitting a one-third contraction in the money supply -- Meltzer reasonably attributes the catastrophe to the confluence of these shocks. But the Fed, which was established after a succession of financial panics in the 19th and early 20th centuries -- precisely to prevent their recurrence -- failed in that narrower mission.
That failure, as Meltzer keenly describes, was a result of misguided policies and political infighting. Policy was ruled by the (wrongheaded) conventional wisdom of the day, that said that the collapse of the 'Thirties was necessary to purge the excesses of the 'Twenties. The Fed was to restrict itself to providing credit solely to meet the private sector's needs -- by buying only "real bills" and not purchasing government securities, which supposedly only pumped up speculative credit, according to the prevailing notion of the time. The reestablishment of the gold standard in the 1920s was considered a success then, but Meltzer describes how it sowed the downturn's seeds. Britain needed to deflate while France and the U.S. had to inflate, so all resisted. New York Fed President Benjamin Strong, who de facto ran policy in the 'Twenties, eased to help the pound. But his jealous counterparts would posthumously blame him for inflating the bubble that burst in 1929.
More important, Meltzer details the dithering that prevented the Fed from taking the most basic monetary action -- large-scale purchases of government securities to add liquidity to the banking system. Fed officials thought policy already was easy because interest rates were near zero and banks didn't borrow from the Fed, ignoring the rise in real interest rates caused by deflation and the contraction in the money stock.
The Bank of Japan repeated those blunders through most of the 'Nineties. The Fed, having learned from history, has not been doomed to repeat it. The U.S. central bank already has slashed its key interest rate target 12 times since January 2001 to a nearly irreducible 1 1/4%. And in a speech last November that still reverberates, Fed Governor Ben Bernanke pointed out that the central bank hasn't run out of monetary bullets even if it runs out of basis points. Even at 0%, the Fed still has a magical device -- the printing press. With a steward of the dollar trumpeting the power to debase it, is it any wonder that gold has rallied and the spread between TIPS (Treasury inflation-protected securities) and fixed-return Treasuries has widened?
Yet the circumstances of the bursting of the bubbles of the 'Twenties and the 'Nineties were markedly different. Ahead of the '29 Crash, the Fed was actively trying to curb speculation. Greenspan & Co. claim no part in the recent bubble, with the Maestro contending that actions to curb the inflation in asset prices posed risks to the economy.
His protest, however, ignores the role played by the Fed in encouraging soaring asset inflation. As previously noted in Barron's, the central bank provided the monetary fuel for the Nasdaq bubble and then throttled it back ("Fed Inflated, Then Burst IPO Bubble," Dec. 11, 2000). Investors and traders also comforted themselves with the notion that the central bank would (and could) rescue the financial markets if they collapsed. That belief, which gained currency especially after the Long Term Capital Management debacle of 1998, came to be known as "The Greenspan Put" -- a get-out-of-jail-free card for speculators.
Now, even though the world enjoys expanding international trade and growth in output and income-exactly the opposite of the 'Thirties -- the Fed still worries about deflation and depression. Moreover, every indicator -- money supply, negative real rates, a steeply sloped yield curve, a weakening dollar and rising commodity prices -- is full-tilt expansionary. Indeed, William Silber of New York University's Stern School recently wrote in the Financial Times that the Fed may not act to curb inflation soon enough -- its blunder of the 1970s. How the Fed failed to foster stable prices after 1951 should be the basis of Meltzer's second volume, which I eagerly await.
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RANDALL W. FORSYTH is an assistant managing editor at Barron's
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