CRISIS The Derivatives Market is Unwinding!

Although this article lacks a bit in the "meat" department, it is clear that the next shoe to drop is going to be the "Derivatives" and when they hit the floor they will be a steal toed boot and make the housing bail out look like some fuzzy bunny slippers.... I do not like what I see.



HeliumAvid

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http://www.ireport.com/docs/DOC-104002



The Derivatives Market is Unwinding!

by George Washington
A couple of months ago, a financial analyst who sells derivatives told me that fears about a meltdown in the derivatives market were unfounded.

Yesterday, he told me - with a very worried look - "the derivatives market is unwinding!"

What does this mean? What are derivatives and why should you care if the market is unwinding?

Well, it turns out that the reason that Bear Stearns was about to go belly-up before JP Morgan bought it is that it had held trillions of dollars in derivatives, which were about to go south. (The reason that JP Morgan was so eager to buy Bear Stearns is that it was on the other side of these derivative contracts -- if Bear Stearns had gone under, JP Morgan would have taken a huge hit. But the way the derivative agreements were drafted, a purchase by JP Morgan canceled the derivative contracts, so that JP Morgan didn't experience huge losses. That is probably why the Fed was so eager to broker - and fund - the shotgun marriage. JP Morgan is a much larger player, and if Bear's failure had caused the derivatives hit to JP Morgan, it probably would have rippled out to the whole financial system and potentially caused an instant depression).

In addition, the subprime prime loan crisis is intimately connected to the unwinding of the derivatives market. Specifically, loans were repackaged into derivatives called collateralized debt obligations (or "CDO's") and sold to both big and regional banks and investment companies worldwide. The CDO's were highly-leveraged -- many times the amount of the actual loans. When the subprime loan crisis hit, the high leverage magnified the fallout, and huge sums of CDO derivatives became essentially worthless.

Do you remember when wealthy Orange County, California, went bankrupt in 1994? Yup, that was because it had invested in bad derivatives (and see this).

And, according to a recent article by one of the world's top derivative insiders, the market for credit default swap ("CDS") derivatives is also unraveling.

And reported just today, Lehman Brothers is now on the edge, due to exposure to derivatives.

Derivatives are the Elephant in the Living Room

The subprime mortgage crisis is bad, and is hurting many people, and slowing the economy. High oil and food prices are bad, and are hurting many people, and bringing down the economy. But -- according to top insiders -- derivatives are the elephant in the room . . . the single largest threat to the U.S. and world economy.

One reason is that, according to Paul Volcker, the former chairman of the Federal Reserve, the entire modern financial system is based upon derivatives, and the financial system today is entirely different from the traditional American or global financial system because derivatives - a relatively new concept - now underly the entire fabric of the financial system. In short, many of the people who know the most about derivatives say that the current system is a house of cards built upon derivatives.

And yet banks and financial houses have hidden their derivatives exposure off the balance sheets. No wonder almost no one understands derivatives:

"Not only Warren Buffett, but Bond King Bill Gross, our Fed Chairman Ben Bernanke, the Treasury Secretary Henry Paulson and the rest of America's leaders can't 'figure out'" the derivatives market.
Indeed, the government may have actively helped to hide the the derivatives mess since at least 2006. For example, according to Business Week:
"President George W. Bush has bestowed on his intelligence czar, John Negroponte, broad authority, in the name of national security, to excuse publicly traded companies from their usual accounting and securities-disclosure obligations."
Former fed chairman Alan Greenspan has been a huge booster for and defender of derivatives for many years. Did you know that the same guy that pushed subprime loans has also aggressively pushed derivatives since at least 2001?

And the other regulatory agencies and Congress have taken a totally hands-off approach towards derivatives.

How Big a Problem?

How big is the derivatives market? Worldwide, it is $516 trillion dollar. The derivatives market dwarfs the real market for goods and services, and acts likes an unregulated black market.

As one writer put it:
"It's all smoke and mirrors. The financial system has decoupled from the productive elements of the economy and is now beginning to show disturbing signs of instability."
And its not just the U.S. Derivatives salesmen have sold these babies all over the world. Because banks, financial institutions and governments world-wide have bought significant derivatives, the fall out will not be limited solely to the U.S. See this and this.

If the derivatives market is truly unwinding, as my investment advisor friend and some of the top industry insiders say, we could be in for a very bumpy ride.

For further information on derivatives, see these articles:

http://www.prudentbear.com/index.php/BearsLairHome
http://www.marketoracle.co.uk/Article4419.html
http://www.marketoracle.co.uk/Article1038.html
http://www.marketoracle.co.uk/Article4378.html
http://www.globalresearch.ca/index.p...xt=va&aid=8634
http://www.telegraph.co.uk/money/mai...3/ccfed123.xml
http://www.nytimes.com/2008/03/23/bu...gewanted=print
http://www.nytimes.com/2008/03/23/bu...l?ref=business
http://www.nytimes.com/2008/03/23/bu...ed=2&th&emc=th
http://money.cnn.com/2008/03/21/markets/dollar/
http://www.ft.com/cms/s/0/803541a6-f...077b07658.html
http://www.occ.treas.gov/ftp/release/2008-36a.pdf
http://news.moneycentral.msn.com/pro...519&id=8667647
http://www.telegraph.co.uk/money/mai...cnlibor117.xml

Well if it is then as the old saying goes, we're screwed.

http://www.globalresearch.ca/index.php?context=va&aid=8634

Credit Default Swaps: Evolving Financial Meltdown and Derivative Disaster Du Jour

by Dr. Ellen Brown

Global Research, April 11, 2008

Author's website www.webofdebt.com/

When the smartest guys in the room designed their credit default swaps, they forgot to ask one thing - what if the parties on the other side of the bet don't have the money to pay up? Credit default swaps (CDS) are insurance-like contracts that are sold as protection against default on loans, but CDS are not ordinary insurance.

Insurance companies are regulated by the government, with reserve requirements, statutory limits, and examiners routinely showing up to check the books to make sure the money is there to cover potential claims. CDS are private bets, and the Federal Reserve from the time of Alan Greenspan has insisted that regulators keep hands off.

The sacrosanct free market would supposedly regulate itself. The problem with that approach is that regulations are just rules. If there are no rules, the players can cheat; and cheat they have, with a gambler's addiction. In December 2007, the Bank for International Settlements reported derivative trades tallying in at $681 trillion - ten times the gross domestic product of all the countries in the world combined. Somebody is obviously bluffing about the money being brought to the game, and that realization has made for some very jittery markets.

“Derivatives” are complex bank creations that are very hard to understand, but the basic idea is that you can insure an investment you want to go up by betting it will go down. The simplest form of derivative is a short sale: you can place a bet that some asset you own will go down, so that you are covered whichever way the asset moves.

Credit default swaps are the most widely traded form of credit derivative. They are bets between two parties on whether or not a company will default on its bonds. In a typical default swap, the “protection buyer” gets a large payoff if the company defaults within a certain period of time, while the “protection seller” collects periodic payments for assuming the risk of default.

CDS thus resemble insurance policies, but there is no requirement to actually hold any asset or suffer any loss, so CDS are widely used just to speculate on market changes. In one blogger's example, a hedge fund wanting to increase its profits could sit back and collect $320,000 a year in premiums just for selling “protection” on a risky BBB junk bond. The premiums are “free” money - free until the bond actually goes into default, when the hedge fund could be on the hook for $100 million in claims. And there's the catch: what if the hedge fund doesn't have the $100 million? The fund's corporate shell or limited partnership is put into bankruptcy, but that hardly helps the “protection buyers” who thought they were covered.

To the extent that CDS are being sold as “insurance,” they are looking more like insurance fraud; and that fact has particularly hit home with the ratings downgrades of the “monoline” insurers and the recent collapse of Bear Stearns, a leading Wall Street investment brokerage. The monolines are so-called because they are allowed to insure only one industry, the bond industry. Monoline bond insurers are the biggest protection writers for CDS, and Bear Stearns was the twelfth largest counterparty to credit default swap trades in 2006.1 These players have been major protection sellers in a massive web of credit default swaps, and when the “protection” goes, the whole fragile derivative pyramid will go with it. The collapse of the derivative monster thus appears to be both imminent and inevitable, but that fact need not be cause for despair. The $681 trillion derivatives trade is the last supersized bubble in a 300-year Ponzi scheme, one that has now taken over the entire monetary system. The nation's wealth has been drained into private vaults, leaving scarcity in its wake. It is a corrupt system, and change is long overdue. Major crises are major opportunities for change.

The Wall Street Ponzi Scheme

The Ponzi scheme that has gone bad is not just another misguided investment strategy. It is at the very heart of the banking business, the thing that has propped it up over the course of three centuries. A Ponzi scheme is a form of pyramid scheme in which new investors must continually be sucked in at the bottom to support the investors at the top. In this case, new borrowers must continually be sucked in to support the creditors at the top. The Wall Street Ponzi scheme is built on “fractional reserve” lending, which allows banks to create “credit” (or “debt”) with accounting entries. Banks are now allowed to lend from 10 to 30 times their “reserves,” essentially counterfeiting the money they lend. Over 97 percent of the U.S. money supply (M3) has been created by banks in this way.2 The problem is that banks create only the principal and not the interest necessary to pay back their loans, so new borrowers must continually be found to take out new loans just to create enough “money” (or “credit”) to service the old loans composing the money supply. The scramble to find new debtors has now gone on for over 300 years - ever since the founding of the Bank of England in 1694 - until the whole world has become mired in debt to the bankers' private money monopoly. The Ponzi scheme has finally reached its mathematical limits: we are “all borrowed up.”

When the banks ran out of creditworthy borrowers, they had to turn to uncreditworthy “subprime” borrowers; and to avoid losses from default, they moved these risky mortgages off their books by bundling them into “securities” and selling them to investors. To induce investors to buy, these securities were then “insured” with credit default swaps. But the housing bubble itself was another Ponzi scheme, and eventually there were no more borrowers to be sucked in at the bottom who could afford the ever-inflating home prices. When the subprime borrowers quit paying, the investors quit buying mortgage-backed securities. The banks were then left holding their own suspect paper; and without triple-A ratings, there is little chance that buyers for this “junk” will be found. The crisis is not, however, in the economy itself, which is fundamentally sound - or would be with a proper credit system to oil the wheels of production. The crisis is in the banking system, which can no longer cover up the shell game it has played for three centuries with other people's money.


The Derivatives Chernobyl

The latest jolt to the massive derivatives edifice came with the collapse of Bear Stearns on March 16, 2008. Bear Stearns helped fuel the explosive growth in the credit derivative market, where banks, hedge funds and other investors have engaged in $45 trillion worth of bets on the credit-worthiness of companies and countries. Before it collapsed, Bear was the counterparty to $13 trillion in derivative trades. On March 14, 2008, Bear's ratings were downgraded by Moody's, a major rating agency; and on March 16, the brokerage was bought by JPMorgan for pennies on the dollar, a token buyout designed to avoid the legal complications of bankruptcy. The deal was backed by a $29 billion “non-recourse” loan from the Federal Reserve. “Non-recourse” meant that the Fed got only Bear's shaky paper assets as collateral. If those proved to be worthless, JPM was off the hook. It was an unprecedented move, of questionable legality; but it was said to be justified because, as one headline put it, “Fed's Rescue of Bear Halted Derivatives Chernobyl.” The notion either that Bear was “rescued” or that the Chernobyl was halted, however, was grossly misleading. The CEOs managed to salvage their enormous bonuses, but it was a “bailout” only for JPM and Bear's creditors. For the shareholders, it was a wipeout. Their stock initially dropped from $156 to $2, and 30 percent of it was held by the employees. Another big chunk was held by the pension funds of teachers and other public servants. The share price was later raised to $10 a share in response to shareholder outrage, but the shareholders were still essentially wiped out; and the fact that one Wall Street bank had to be fed to the lions to rescue the others hardly inspires a feeling of confidence. Neutron bombs are not so easily contained.

The Bear Stearns hit from the derivatives iceberg followed an earlier one in January, when global markets took their worst tumble since September 11, 2001. Commentators were asking if this was “the big one” - a 1929-style crash; and it probably would have been if deft market manipulations had not swiftly covered over the approaching catastrophe. The precipitous drop was blamed on the threat of downgrades in the ratings of two major monoline insurers, Ambac and MBIA, followed by a $7.2 billion loss in derivative trades by Societe Generale, France's second-largest bank. Like Bear Stearns, the monolines serve as counterparties in a web of credit default swaps, and a downgrade in their ratings would jeopardize the whole shaky derivatives edifice. Without the monoline insurers' traiple-A seal, billions of dollars worth of triple-A investments would revert to junk bonds. Many institutional investors (pension funds, municipal governments and the like) have a fiduciary duty to invest in only the “safest” triple-A bonds. Downgraded bonds therefore get dumped on the market, jeopardizing the banks that are still holding billions of dollars worth of these bonds. The downgrade of Ambac in January signaled a simultaneous downgrade of bonds from over 100,000 municipalities and institutions, totaling more than $500 billion.3

Institutional investors have lost a good deal of money in all this, but the real calamity is to the banks. The institutional investors that formerly bought mortgage-backed bonds stopped buying them in 2007, when the housing market slumped. But the big investment houses that were selling them have billions' worth left on their books, and it is these banks that particularly stand to lose as the derivative Chernobyl implodes.4

A Parade of Bailout Schemes

Now that some highly leveraged banks and hedge funds have had to lay their cards on the table and expose their worthless hands, these avid free marketers are crying out for government intervention to save them from monumental losses, while preserving the monumental gains raked in when their bluff was still good. In response to their pleas, the men behind the curtain have scrambled to devise various bailout schemes; but the schemes have been bandaids at best. To bail out a $681 trillion derivative scheme with taxpayer money is obviously impossible. As Michael Panzer observed on SeekingAlpha.com:

As the slow-motion train wreck in our financial system continues to unfold, there are going to be plenty of ill-conceived rescue attempts and dubious turnaround plans, as well as propagandizing, dissembling and scheming by banks, regulators and politicians. This is all happening in an effort to try and buy time or to figure out how the losses can be dumped onto the lap of some patsy (e.g., the taxpayer).

The idea seems to be to keep the violins playing while the Big Money Boys slip into the mist and man the lifeboats. As was pointed out in a blog called “Jesse's Café Americain” concerning the bailout of Ambac:

It seems that the real heart of the problem is that AMBAC was being used as a "cover" by the banks which originated these bundles of mortgages to get their mispriced ratings. Now that the mortgages are failing and the banks are stuck with them, AMBAC cannot possibly pay, they cannot cover the debt. And the banks don't wish to mark these CDOs [collateralized debt obligations] to market [downgrade them to their real market value] because they are probably at best worth 60 cents on the dollar, but are being held by the banks on balance at roughly par. That's a 40 percent haircut on enough debt to sink every bank involved in this situation . . . . Indeed for all intents and purposes if marked to market banks are now insolvent. So, the banks will provide capital to AMBAC . . . [but] it's just a game of passing money around. . . . So why are the banks engaging in this charade? This looks like an attempt to extend the payouts on a vast Ponzi scheme gone bad that is starting to collapse . . . .5

The banks will therefore no doubt be looking for one bailout after another from the only pocket deeper than their own, the U.S. government's. But if the federal government acquiesces, it too could be dragged into the voracious debt cyclone of the mortgage mess. The federal government's triple A rating is already in jeopardy, due to its gargantuan $9 trillion debt. Before the government agrees to bail out the banks, it should insist on some adequate quid pro quo. In England, the government agreed to bail out bankrupt mortgage bank Northern Rock, but only in return for the bank's stock. On March 31, 2008, The London Daily Telegraph reported that Federal Reserve strategists were eyeing the nationalizations that saved Norway, Sweden and Finland from a banking crisis from 1991 to 1993. In Norway, according to one Norwegian adviser, “The law was amended so that we could take 100 percent control of any bank where its equity had fallen below zero.”6 If their assets were “marked to market,” some major Wall Street banks could already be in that category.

Benjamin Franklin's Solution

Nationalization has traditionally had a bad name in the United States, but it could be an attractive alternative for the American people and our representative government as well. Turning bankrupt Wall Street banks into public institutions might allow the government to get out of the debt cyclone by undoing what got us into it. Instead of robbing Peter to pay Paul, flapping around in a sea of debt trying to stay afloat by creating more debt, the government could address the problem at its source: it could restore the right to create money to Congress, the public body to which that solemn duty was delegated under the Constitution.

The most brilliant banking model in our national history was established in the first half of the eighteenth century, in Benjamin Franklin's home province of Pennsylvania. The local government created its own bank, which issued money and lent it to farmers at a modest interest. The provincial government created enough extra money to cover the interest not created in the original loans, spending it into the economy on public services. The bank was publicly owned, and the bankers it employed were public servants. The interest generated on its loans was sufficient to fund the government without taxes; and because the newly issued money came back to the government, the result was not inflationary.7 The Pennsylvania banking scheme was a sensible and highly workable system that was a product of American ingenuity but that never got a chance to prove itself after the colonies became a nation. It was an ironic twist, since according to Benjamin Franklin and others, restoring the power to create their own currency was a chief reason the colonists fought for independence. The bankers' money-creating machine has had two centuries of empirical testing and has proven to be a failure. It is time the sovereign right to create money is taken from a private banking elite and restored to the American people to whom it properly belongs.

Ellen Brown, J.D., developed her research skills as an attorney practicing civil litigation in Los Angeles. In Web of Debt, her latest book, she turns those skills to an analysis of the Federal Reserve and "the money trust." She shows how this private cartel has usurped the power to create money from the people themselves, and how we the people can get it back. Her eleven books include the bestselling Nature's Pharmacy, co-authored with Dr. Lynne Walker, which has sold 285,000 copies. Her websites are www.webofdebt.com and www.ellenbrown.com .

NOTES


1 “Credit Swap Worries Go Mainstream,” nakedcapitalism.com (February 17, 2008); Aline van Duyn, “CDS Sector Weighs Bear Stearns Backlash,” Financial Times (London) (March 16, 2008).

2 See Ellen Brown, “Dollar Deception: How Banks Secretly Create Money,” webofdebt.com/articles (July 3, 2008).

3 “Monoline Insurance,” Wikipedia.

4 Jane Wells, “Ambac and MBIA: Bonds, Jane's Bonds,” CNBC (February 4, 2008).

5 “Saving AMBAC, the Homeowners, or the Banks?”, Jesse's Café Americain (February 25, 2008).

6 Ambrose Evans-Pritchard, “Fed Eyes Nordic-style Nationalisation of US Banks,” International Business Editor (March 31, 2008).

7 See Ellen Brown, Web of Debt (Third Millennium Press, 2008), chapter 3.



Ellen Brown is a frequent contributor to Global Research. Global Research Articles by Ellen Brown

Thanks HeliumAvid for keeping us informed! I finish one thread and up pops another, even worse that the last. Even though we've known this was coming, it's all just too much, even for me. As you probably remember, I work for Genentech in SSF and we had a voluntary lay-off this last Spring. I wasn't so sure that I should take it back then, but now, I wish I had along with a tidy sum of cash. I feel a general, involuntary lay-off coming. Our industry uses up an enormous amount of resources and the costs of research, clinical trials and manufacturing is staggering. We also have a looming buyout by a Swiss pharmaceutical, which may be good, but still might want to reduce the workforce. All in all, I'm not sure where we will go or if we'll just stay put. Add to this a road trip to Las Vegas in the next two weeks to attend a funeral (have to go), I'm feeling rather apprehensive.

But, mainly, I just wanted to thank you and all the others who do a damn good job at keeping us informed.

The more I read about this stuff, the more my hair hurts. How in the world can a system be in debt more than ten times the GDP of all countries combined? I just can't get my mind wrapped around this. I don't think I can possibly understand this. I am only an engineer, I studied the easy stuff, like calculus, chemistry, physics, etc. This high flying finance is like an alien world to me. Suffice to say, it must be bad, really, really bad. At least if I get shot with a 9MM, I can comprehend what happened. I feel like a cave man examining a laptop.

I feel like a cave man examining a laptop.

Click to expand...

me too.

To be honest, I will have to read your threads a couple of times in order to grasp everything...all so over my head, but have comprehended enough so far to know that we are in deep doo doo. Thank you HelliumAvid, so very much for helping us all understand the extreme tangled web our financial system is in.

IIRC the group that referees settlement of these wonderful financial items is performing its duties over the next three weeks (as it doubtless does periodically).


"...the people who know the most about derivatives say that the current system is a house of cards built upon derivatives..."


Can we say cascading cross-defaults?

Kook said:

I feel like a cave man examining a laptop.

Click to expand...

Wow, that is exactly how I feel and have been feeling about quite a few things lately. Trying to wrap my mind around the economic crisis that we are in and the huge numbers being tossed around like play money, just seems impossible for me. It is frustrating beyond belief and I am having some trouble figuring out how deal with the emotions that go along with not being able to really understand it all. All that I really know to do is pray and prep as well as I can.


Angel Lady

Kook said:

The more I read about this stuff, the more my hair hurts. How in the world can a system be in debt more than ten times the GDP of all countries combined? I just can't get my mind wrapped around this. I don't think I can possibly understand this. I am only an engineer, I studied the easy stuff, like calculus, chemistry, physics, etc. This high flying finance is like an alien world to me. Suffice to say, it must be bad, really, really bad. At least if I get shot with a 9MM, I can comprehend what happened. I feel like a cave man examining a laptop.

Click to expand...

AMEN brother ... I know what you mean! For me, dark matter is easier to comprehend. Which means these financial geniuses that designed this stuff are either really, really, really, smart - or dangerously stupid! History will tell us which ... but so far it ain't looking very faltering.

Observer999 said:

AMEN brother ... I know what you mean! For me, dark matter is easier to comprehend. Which means these financial geniuses that designed this stuff are either really, really, really, smart - or dangerously stupid! History will tell us which ... but so far it ain't looking very faltering.

Click to expand...

They're dangerously sleazy.

They're stupid.

Observer999 said:

AMEN brother ... I know what you mean! For me, dark matter is easier to comprehend. Which means these financial geniuses that designed this stuff are either really, really, really, smart - or dangerously stupid! History will tell us which ... but so far it ain't looking very faltering.

Click to expand...

They're stupid but they all have bought into the same stupid.

You know how the hype for the bail out doesn't make any sense? It's not that we don't understand it. It's that they have the same stupid.

They're worried about their ten million dollar bonuses and CDO swaps. What does that have to do with us?

If the economy craters out, they lose, not us.

I understand very well how they've spun it to get everyone involved. "Sure, I, the investment banker/broker will lose my ten million dollar bonus but this is about a million little people losing ten dollars."

As one of those million, I say, bring it on. I can spare the ten bucks.

Kook said:

The more I read about this stuff, the more my hair hurts. How in the world can a system be in debt more than ten times the GDP of all countries combined? I just can't get my mind wrapped around this. I don't think I can possibly understand this. I am only an engineer, I studied the easy stuff, like calculus, chemistry, physics, etc. This high flying finance is like an alien world to me. Suffice to say, it must be bad, really, really bad. At least if I get shot with a 9MM, I can comprehend what happened. I feel like a cave man examining a laptop.

Click to expand...

yep, imagine how I feel - I am not even an engineer - One thing I get from all of this though - We are in a heep of trouble.....

"I understand very well how they've spun it to get everyone involved. "Sure, I, the investment banker/broker will lose my ten million dollar bonus but this is about a million little people losing ten dollars."

As one of those million, I say, bring it on. I can spare the ten bucks."

Fine, except we're not going to lose "ten bucks". We're going to lose everything.

Kook said:

The more I read about this stuff, the more my hair hurts. How in the world can a system be in debt more than ten times the GDP of all countries combined? I just can't get my mind wrapped around this. I don't think I can possibly understand this. I am only an engineer, I studied the easy stuff, like calculus, chemistry, physics, etc. This high flying finance is like an alien world to me. Suffice to say, it must be bad, really, really bad. At least if I get shot with a 9MM, I can comprehend what happened. I feel like a cave man examining a laptop.

Click to expand...

If one engineers anything mechanical and designs it for a given load everything works great. If however that thing is continuously overloaded it is only a matter of time until it fails. The financial system was reasonably sound until these financial geniuses (read mouth breathing morons) found out they could put money in THEIR pockets by overloading the banking system.....well it is only a matter of time before it fails.

Think of these brainacs as using a crane to hoist money up to their penthouses, the found that by doubling the load of money the could get rich quicker, the problem is these people thought they were too smart for physical reality to apply to them and now the crane is buckling under the overload. When it collapses it is going to kill bystanders on the streets below.

For me, dark matter is easier to comprehend.

Observer,

Just think of this as "dark money" then. It is, you know. That's pretty much what some sources have called it in the past- only they refer to it as "dark pools."

And you thought the derivatives world was bad...

dd
====

http://www.portfolio.com/news-marke.../2007/07/06/Dark-Pools-Grow-Scrutiny-Does-Not

Will Dark Pools Swallow Wall Street?
by Kit R. Roane Jul 9 2007

In search of lower prices, less scrutiny, and fewer rules, some of the biggest securities traders are turning to private exchanges called dark pools to make their biggest deals.

Dark liquidity pools may sound like something out of science fiction, but they're real. And they're already spreading throughout Wall Street.

These pools are basically internal systems for trading stocks privately, off of public exchanges and out of the public eye. They are growing rapidly, both in number and in volume of trades.

Behind the boom in dark pools are large hedge funds and institutional clients that want to build and liquidate large stock positions at lower costs, while also being shielded from those who might profit by knowing their intentions.

An activist hedge fund, for instance, may not want to reveal that it is buying up large blocks of stock in a company it is about to attack, or a mutual fund might want to sell a large amount of stock without causing a downdraft that would hurt any shares it still holds.

But these alternative trading systems have also raised concerns as they have multiplied over the last two years. Poking fun at some of the hand-wringing over these secretive pools, the Securities and Exchange Commission's libertarian-leaning commissioner, Paul Atkins, joked recently that someone should make a horror movie about them, perhaps called The Dark Pool That Swallowed Manhattan!.

Jokes aside, major stock exchanges have some reasons to be nervous about the dark pools' proliferation. The mainstream exchanges see the pools as yet another group attempting to steal revenue-producing trades and liquidity from their markets. That's in addition to a welter of new electronic-trading platforms that offer faster execution and lower transaction costs. These platforms alone have triggered a wave of consolidation among traditional exchanges.

Exchanges are at a disadvantage as they try to compete with dark pools. The S.E.C. regulates traditional exchanges, and new rules being phased in over the next few months will require them to share information fairly and mandate that trades be routed to whichever exchange gives the best and fastest price.

Dark pools, by contrast, can largely avoid regulation if they keep their trading volumes under a set threshold. This makes them attractive to big institutional traders seeking to avoid being so transparent about their trading patterns that competitors can anticipate their actions or otherwise gain an edge.

The S.E.C., meanwhile, is worried that the fundamental lack of transparency in these pools might lead to price manipulation or other abuses.

The idea behind dark pools isn't exactly new. Brokerages have long tried to cross (or satisfy) trades internally, by matching one customer's sale with another customer's purchase. The first true dark pool is believed to be Investment Technology Group's two-decade-old Portfolio System for Institutional Trading, or Posit.

But now new technologies have combined with market changes to make these alternative, private exchanges a hotter place to invest.

The consolidation of public stock exchanges, the rise of slice-and-dice algorithmic trading, and new regulations—including order-handling rules—have had the effect of reducing liquidity, or ease of trading, in the public markets.

They have also led to a shrinkage of order size, so it has become increasingly difficult to buy or sell a large block of stock without being noticed—and thereby, often, moving the price of the underlying security.

Meanwhile, sophisticated electronic-trading systems have made buying and selling away from public markets both easier and more efficient. There are even new systems aimed at providing access to large numbers of dark pools.

For hedge funds, pension funds, and other big traders, the beauty of the system is that it can often allow these institutional investors to use the public markets to set stock prices while they buy and sell stock discreetly and at set terms in a private market.

"The public exchange is mandated to be equal and fair and open," says Jeromee Johnson, a senior analyst at Tabb Group, a firm that conducts research into and provides advice about financial markets. "The dark pools don't have to provide equal and fair access or, necessarily, a level playing field."

"And for institutions," he adds, "it can mean a better execution because they are able to protect the information about the size and type of their order and negotiate with the other counterparties."

It can also be cheaper than having a broker-dealer route the order onto the public market.

As an example, Johnson uses a simple scenario in which a relatively illiquid—that is, infrequently traded—stock has a three-cent spread between the bid and the ask price. An institution wanting to buy or sell a quarter-million shares would save several thousand dollars (the difference between the public bid and ask prices) by making the trade in a dark pool.

Of even greater importance would be the additional value of eliminating the spike in supply or demand caused by its big order, which would lead to a swing in the stock's price. "The potential value of savings on the transaction could be in the 80 or 90 percent range," Johnson says. "These are significant savings."

The hunger for anonymous block trading has caused the field to explode. There are about 40 active pools, double the number just last year. New pools and services to aggregate them are announced almost every month.

The pools control about 512 million shares per day in trades, or about 10 percent of all equity shares traded in the United States, according to data compiled by the Tabb Group.
Nearly every major Wall Street institution seems to have a system in place, from Goldman Sachs' Sigma X and Merrill Lynch's Block Alert to the consortium-owned BIDS network, whose principals include Bank of America, Bear Stearns, and Deutsche Bank.

Each system has its own character, with some allowing negotiated prices and others setting prices based on the quotes in the public markets. Some systems only allow large orders, while others will mix small orders in the trades. A few—worried about manipulation—won't let hedge funds in the door. But others welcome them because they bring liquidity.

Hedge funds were early adopters of the computer algorithms used to find and exploit price discrepancies in dark pools. These algorithms are now so important to the business that Citigroup recently developed a new one, called I.S. Shadow, just to assuage the concerns of two funds that weren't able to complete enough of the profitable trades they had found.

Backers of the pools are attracted to the game because it is lucrative. By satisfying orders internally, they not only avoid stock exchange trading fees but also get paid to make the trades.

Liquidnet, for instance, reported an average daily volume of nearly 57 million shares in the U.S. during the first quarter of 2007, a 28 percent increase from the same quarter in 2006. This seven-year-old company has become the ninth-largest broker on the New York Stock Exchange and is estimated to be worth more than $2 billion.

The Tabb Group predicts that these internal crossing networks and internal markets will continue to eat into the market share of the public exchanges, trading nearly 1.5 billion shares per day by 2010, an annual growth rate of more than 40 percent. That would equal about 15 percent of all equity shares traded in the United States.

By comparison, the N.Y.S.E.'s market share is expected to fall to 32 percent in 2010, from about 40 percent this year, while the Nasdaq is expected to lose just over six percentage points of its current market share over that period, falling to 34 percent.

Public exchanges have been fighting back with plans for their own anonymous-trading systems.

At the same time, Catherine Kinney, the N.Y.S.E.'s president, has attempted to rally opposition to dark pools. She has argued in conferences that private exchanges are already hurting investors by reducing the information that public markets use to set stock prices.

Adding insult to injury, dark pools often use retail investors' money to increase their liquidity. Charles Schwab, for instance, sends some retail-order flow into a dark pool owned by UBS.
The Tabb Group's Johnson explains: "So the institutions are able to take a large order and park it in the pool, then let the non-educated retail flow pass through," nibbling away at it but without being able to see the large block aching to be filled or being able to affect the price being paid for the shares.

These are just niggling concerns compared with the problems such pools might bring if they continue to scarf up market share at their current rapid pace. Something ugly could be around the bend.

"As these dark pools grow, then the public—you and I—will get less liquidity in the sense of price," says Boston University Law professor Tamar Frankel, a securities and regulation expert.

"There will come a point," she adds, "where the price on the open exchanges will not be sufficiently informative, and that will hurt everybody, even the parties that trade on these dark exchanges, because the price may no longer be representative of the true value of the shares."

The S.E.C., meanwhile, is worried that the fundamental lack of transparency in these pools might lead to price manipulation or other abuses.

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Ya think???


nanna

Observer999 said:

AMEN brother ... I know what you mean! For me, dark matter is easier to comprehend. Which means these financial geniuses that designed this stuff are either really, really, really, smart - or dangerously stupid! History will tell us which ... but so far it ain't looking very faltering.

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they are not geniuses they merely have the mentality to understand this stuff, a way of thinking, it is purposely shielded from the public by ignorant journalists and politicians who haven't a clue, the banking system is rarely understood outside of those who work in it, who strive to create the mysticism that surrounds it, if it was clearly explained to the public then perhaps that would help, or perhaps there would be calls for monetary reform

Richard said:

they are not geniuses they merely have the mentality to understand this stuff, a way of thinking, it is purposely shielded from the public by ignorant journalists and politicians who haven't a clue, the banking system is rarely understood outside of those who work in it, who strive to create the mysticism that surrounds it, if it was clearly explained to the public then perhaps that would help, or perhaps there would be calls for monetary reform

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The only thing there is to understand is mere theories and concepts the masters of disempowerment have dreamed up. Obfuscation and deliberate complication.

Economics, Politics and Law are NOT sciences based on absolutes. They are concepts and theories made up by men and enforced upon the populace as the mass reality. They are all subject to change via the whims and tides of social trends and events.

Shooting Star said:

yep, imagine how I feel - I am not even an engineer - One thing I get from all of this though - We are in a heep of trouble.....

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Fifty years ago, I couldn't even spell "engineer". Now I are one....

Kook said:

The more I read about this stuff, the more my hair hurts. How in the world can a system be in debt more than ten times the GDP of all countries combined? I just can't get my mind wrapped around this. I don't think I can possibly understand this. I am only an engineer, I studied the easy stuff, like calculus, chemistry, physics, etc. This high flying finance is like an alien world to me. Suffice to say, it must be bad, really, really bad. At least if I get shot with a 9MM, I can comprehend what happened. I feel like a cave man examining a laptop.

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Well if you add up your homeowners, auto and life insurance, Im sure you have more coverage than you make in a year.

Alot of these contract spreads could be 20 to 50 years when talking about bonds and mortgage securities. As the mortgage securities payoff, the counter party risk declines as what they have to cover is becoming less and less. Bonds come due at the end of their term and could be a total loss to the counter party if the default, minus the fees paid for the insurance.

Now this is where it gets interesting, the counter parties will also buy derivatives that help them spread the risk further. Lets say the security is a billion dollars in farm loans, not only are they covered like above, but the counter parties will buy derivatives that the weather will be bad in the growing area, another derivative will speculate on corn prices going up or down and the wall street wizard will package out the risk.

Let say it was a bad farm year and the loans where only paid back 75%, well that means $250 million has to be put, not the original billion. Looking at the one deal it may look like there are several billion in derivatives, but in the end its still only the $250 in million that needs to be covered.

Because it is so sliced and resliced, packaged and repackage alot of the hedge funds, banks and investors do not know what there exposure is to them. Is also hard to know who all you counterparties are, so with the loss of confidence, you dont know if they counter party will be able to pay up.

That why banks what to stay liquid, the are not sure 100% where they stand at the moment. They want to keep the money to cover their losses that they may not even have. Thus the credit crisis we are in and why I dont think the $700 billion bailout is not going to fix it, its just going to give the system more time to unwind.

On monday, there will be a good case study. Fannie and freddie derivatives are to be settled and payment is to be made with in 10 days. This will suck billions out of some parts of the market and it will move to other area's, also payees may have to sell things to pony up the cash, there fore expect huge surges down in the market followed by some buing and increases on somedays, there will be some flight to safety so treasuries will have low almost 0 yields in the short term.

Anways, this freddie, fannie action would be a good place to watch this market in action. Lehman and WAMU have thier actions in two weeks. Traders are the most worried at the lehman action, becuase compared to all the others they were the counterparty.

The fat lady will sing soon, and we will not like her song one bit.

Settlement day approaches for derivatives

Perhaps this is why the 7th keeps coming up as the date.

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Settlement day approaches for derivatives

By Aline van Duyn in New York

Published: October 1 2008 03:00 | Last updated: October 1 2008 03:00

The $54,000bn credit derivatives market faces its biggest test this month as billions of dollars worth of contracts on now-defaulted derivatives on Fannie Mae, Freddie Mac, Lehman Brothers and Washington Mutual are settled.

Because of the opacity of this market, it is still not clear how many contracts have to be settled and whether payouts on the defaulted contracts, which could reach billions of dollars, are concentrated with any particular institutions.

According to dealers, insurance companies and investors such as sovereign wealth funds, which are widely believed to have written large amounts of credit protection through credit default swaps on financial institutions, could have to pay out huge amounts.

"There is a lot at stake," said an executive at one big dealer. "This is a crisis time, and if these auctions do not go well, or if the amounts investors and dealers have to pay is seen as not being fair, it could have further negative repercussions on the CDS market."

The "auction season" starts tomorrow, when the International Swaps and Derivatives Association has scheduled an auction for Tembec, a Canadian forest products company. This is followed by Fannie Mae and Freddie Mac auctions on October 6. Then, Lehman is settled on October 10, and Washington Mutual is scheduled for October 23.

Even though it is possible that some participants in the credit derivatives market will have to make large payouts, the flipside is there could also be big winners. For every loss in credit derivatives, there is a gain.

The amount of contracts outstanding that reference Fannie Mae and Freddie Mac alone is estimated to be up to $500bn. The default was triggered under the terms of derivatives contracts by the US government's seizure of the mortgage groups, even though the underlying debt is strong after the explicit government guarantee.

The CDS contract settlement could result in billions of dollars of losses for insurance companies and banks that offered credit insurance in recent months. The recovery value will be set by auction. Usually, the bond that is eligible for the auction that trades at the lowest price - the so-called cheapest-to-deliver - is the one that sets the overall recovery value for the credit derivatives.

In the Lehman case, numerous banks and investors have already made losses due to exposure to Lehman as a counterparty on numerous derivatives trades. The auctions next week are for credit derivatives which have Lehman as a reference entity. There are likely to be fewer contracts outstanding than for Fannie Mae and Freddie Mac because Lehman was not included in many of the benchmark credit derivatives. However, exposure remains unclear, which is one concern that regulators now have about the credit derivatives market.

Lehman's bonds have been trading between 15 and 19 cents on the dollar, meaning investors who wrote protection on a Lehman default will have to pay out between 81 and 85 cents on the dollar, a relatively high pay-out.

The previous biggest default in credit derivatives was for Delphi, the US car parts maker that went bankrupt in 2005 and which had about $25bn of CDS.

http://www.ft.com/cms/s/0/6beabcdc-8f51-11dd-946c-0000779fd18c.html?nclick_check=1