mandag den 22. december 2008

IMF awakening to fight the Weapons of Financial Mass Destruction

(Picture: Icelandic SUV's parked after the crisis - source: IMF)

According to a number of speeches from high level officers within the IMF these last few days, IMF has finally realized the magnitude of the financial crises, and at a meeting in Madrid on December 15, the managing director of the Fund, Dominique Strauss-Kahn was cited to have said that the international community would have to come up with at least 2% of the Worlds’ expected total GDP in order to combat the crisis.

A few days before this speech, his first deputy director, John Lipsky, addressed a conference in Steigenberger Hotel, Frankfurt via a Videoconference link from Washington D.C. He stressed the severity and depth of the crisis, loss of consumer confidence and the impact on the emerging economies. He said:

“In November, the IMF revised down its forecast for global growth, less than a month after the publication of its October World Economic Outlook. Based on current policies, the world economy is projected to grow by 2¼ percent in 2009, down from about 5 percent in 2007, before picking up in 2010. The major advanced economies are in recession, and activity is expected to contract by ¼ percent on an annual basis in 2009, marking the first annual contraction in the post-war period for this group of countries.”

The most interesting part of his pitch was the underpinning of the need for what he called a reform of the financial architecture:

These include the design of financial regulation; the assessment of systemic risk; and creating mechanisms for more effective international action to reduce the risk of crises, and to address them when they occur.

Financial innovation and integration also have increased the speed and extent to which shocks are beingtransmitted across asset classes and countries, and have blurred boundaries, including between systemicnon-systemic institutions. Regulation and supervision, however, remain geared at individual financialadequately consider the systemic and international aspects ofdomestic institutions' actions. ...

The challenge, therefore, is to design new rules and institutions that reduce systemic risks, improve financial intermediation, and properly adjust the perimeter of regulation and supervision, but without imposing unnecessary burdens.”

What John Lipsky is pointing at is that one of the most important powers beyond the speed of of the crisis are the so-called financial derivatives combined with a lack of international assessment of the real risk of these ‘inventions’. He stated that the crisis has underscored the tension between globally active financial institutions and nationally bounded regulators and supervisors.

And his final sentence was:

“Enhanced information provision will also be important for improving the assessment of any build up of systemic risks. This will require reviewing transparency, disclosure and reporting rules. Information requirements will also need to cover a larger set of institutions, from insurance companies to hedge funds and to off-balance sheet entities.”

This very much reflects my own earlier remarks on the need for a complete restructuring and possible combination of IMF, G20 and the World Bank with equal voting rights also for the BRICcountries.

Dominique Strauss-Kahn’s speech in Madrid on December 15 had similar and maybe even more stressing points; the purpose of the meeting was to celebrate Spain’s 50th anniversary as member of IMF. Dominique Strauss-Kahn said that action is needed on three fronts to prevent the current recession turning into a global depression:

• Coordinated government intervention in financial markets to get credit flowing and support bank recapitalization

• Fiscal measures to offset the abrupt fall in private demand

• Liquidity support for emerging market countries to reduce the adverse effects of the widespread capital outflows triggered by the financial crisis.

In some of the starkest language he has used since the crisis erupted, Strauss-Kahn said governments around the world have endorsed this agenda, most recently at the November meeting of the Group of 20 (G-20) industrialized and emerging market countries in Washington. "Many have begun to implement it. But the actions taken so far are not enough. We need more," he said, according to the text of remarks as prepared for delivery.

According to the most recent IMF forecast, the major advanced economies are expected to contract by ¼ percent on an annual basis in 2009, marking the first annual contraction in the post-war period for this group of countries. But with the effects of the crisis spreading rapidly, IMF First Deputy Managing Director John Lipsky has said that the Fund is likely to revise downward its global forecast when it announces new numbers next month.

"We are facing an unprecedented decline in output, we have evidence of substantial uncertainty limiting the effectiveness of some fiscal policy measures, and we anticipate that the negative growth effects will last for some time. For all of these reasons we are calling for stimulus measures that are large and diversified, and that will last longer than one or two quarters," said Strauss-Kahn.

His main points were that a lot of fiscal measures can be effectively applied to maximize the multiplier effect of different fiscal measures. Actions could include support to housing and finance; transfers to low-income families, greater provision of unemployment benefits, improved tax benefits for low-wage earners, and expansion of benefits and spending on major projects—particularly those that are already planned and could be implemented quickly, as time is everything.
But the IMF would not recommend reduction in corporate tax rates, dividends and capital gains taxes, or special incentives for businesses. "These are likely to be ineffective and difficult to reverse," Strauss-Kahn said. This is quite remarkable considering the pressure on Washington to help the troubled car makers in US. Let us look at the indications from IMF that the real problem behind the crisis might be the so-called derivatives.

Looking into the history of derivatives we find some real horrors – not least in the reason for why they were created in the first place. Of course neither IMF nor any of the heavy weights in the Financial Sector had warned (sufficiently) or earlier against these derivatives, except a few remarkable persons, which I will come back to.

But these days the papers and blogs are filled of stories like this one:

The 58 Trillion $ Elephant in a room

Jesse Essinger has a fine description of what compared to these 58 Trillions $ elephant in a room:

“The history behind the derivatives seems to be an invention by a team of JP Morgan’s top economists around 1995 at a time when Morgan’s books were under pressure; they had reached the practical maximum of guarantees to private companies, and if they extended these credit lines, they would very soon run the risk of crossing the line of solvency according to standard regulation terms.

So the idea that the team came up with was derivatives”

The idea behind the construction is that if you can sell somebody a lottery ticket that the guarantees you issue to a third party company and that other wise should have been shown on your books, now gives you the opportunity to keep your guarantees and credit lines to lenders out of the books, and in this way leverage your equity way beyond what the normal national financial rules would allow. And as you sell these lottery tickets all over the World in a global sweepstake, other financial institutions can make additional lotteries out of the original lottery making it completely impossible to estimate the real risk. The 58 Trillion Dollars is probably on the low side.

Jesse Essinger collected this interesting timeline of the derivatives and what created a need for them: (View an interactive timeline of derivatives.)

What is interesting to note is that it was far down the road before the real poison of the derivatives finally dawned on Wall Street. And Paulson, Treasury Secretary, didn’t recognize it even if the system was collapsing around him. The deal makers continued selling derivatives during the melt down. But somebody did notice the problem behind the derivatives.

As early as in 1998 Long Term Capital Management (“LTCM”) encountered financial difficulties that required a bailout by banks, orchestrated by the Federal Bank of New York. LTCM is now forgotten and the lessons were forgotten surprisingly quickly.

Also this link contains the story of Amaranth: (Edited by Satyajit Das, the author of ‘Traders, Guns & Money’ Buy his book here:

“Amaranth was a multi-strategy hedge fund. Amaranth Advisors started life as a convertible arbitrage fund (a relatively low risk trading activity). The fund was a recent entrant into energy trading – an infinitely more volatile activity. Just before it blew up, the hedge fund had assets of $9.2 billion. Amaranth's investor base is believed to include funds of funds at major investors such as Goldman Sachs, Morgan Stanley, Credit Suisse, Bank of New York, Deutsche Bank and Man Group. Amusingly, Amaranth claimed to have “best-practice” risk management.

Risk Models – Nick Maounis after the losses surfaced, noted: “Although the size of our natural gas exposure was large, we believed, based on input from both our trading desk and the stress testing performed by our energy risk team, that the risk capital ascribed to the natural gas portfolio was sufficient”. It is questionable that the risk models used were appropriate. For example, correlation risk (one of the main risks in relative value trading) is not generally well captured in traditional risk models. A cursory review of the events shows the inherent limitations of the risk models used. Amaranth took approximately 80 trading days to make $ 2 billion through the end of April and approximately 20 trading days to lose $ 1 billion in May 2006. Amaranth also took twelve trading days to lose a reported $4.44 billion through September 18th or a daily average of close to $ 370 million. Further, when the sale of the energy book was announced on Wednesday, 20 September, the losses were approximately $6 billion and the average daily loss for September expanded to $ 420 million per trading day.”

The story of derivatives also contains other names of interest – Robert Reoch and Blythe Masters seem to be the most notorious:

Robert Reoch

Blythe Masters Called: 'The woman that invented the Weapon of financial Mass Destruction'

As the story goes: “In 1997, she and a team developed many of the credit derivatives that were intended to remove risk from companies' balance sheets. The idea was to separate the default risk on loans from the loans themselves. The risk would be moved into an off-balance sheet vehicle. The product was called Bistro, otherwise known as broad index secured trust offering.

In a guide to understanding the instruments she had created, Masters sung their praises: "In bypassing barriers between different classes, maturities, rating categories, debt seniority levels and so on, credit derivatives are creating enormous opportunities to exploit and profit from associated discontinuities in the pricing of credit risk."

The banks argued that by trading credit derivatives of the kind pioneered by Masters, they had spread their risk elsewhere and therefore needed lower reserves to protect against loan defaults. Regulators rolled over and the banks loaned ever more. It was a huge success and the market for credit derivatives grew rapidly.”

Follow this link and read Elana Centors article on Blythe Masters: On the game plan for derivatives:

It is fantastic to read Blythe Masters comment on her invention: “By enhancing liquidity, credit derivatives achieve the financial equivalent of a free lunch, whereby both buyers and sellers of risk benefit from the associated efficiency gains.

But she wasn’t alone – read about: Bill Demchak – co-inventor of derivatives . And learn about Bill Demchak’s status since 2002: See Bill Demchak Forbes notes

Already in 2002 the Market for derivatives was exploding:

At stake is the unfathomable $56 trillion notional value of derivatives contracts between U.S. commercial banks and counterparties, measured by the Office of the Comptroller of the Currency at the end of 2002. The entire market, around the world, is estimated at over $100 trillion. But such notional amounts--the face amount of the underlying security--are rarely realized

But also Alan Greenspan: did what he could to let the derivatives go on the run: In 1994, a bi-partisan bill was introduced in Congress to tighten the supervision of the complex and growing derivatives in the banking industry. The bill would have had the regulatory agencies establish standards for capital requirements, disclosure, accounting and examinations and audits. As expected, the banks argued that no new laws were needed. Greenspan sealed the legislation's defeat by testifying that the Fed had the powers it needed and that a taxpayer bailout caused by derivatives was remote.
Read the comments on Forbes here. (“The great Derivatives Melt down”)

As a closing conclusion on these ‘Weapons of Mass Destruction’ (More real than some other WMD) – a PDF from the originator, JP Morgan’s Guide:

JP Morgans Guide to credit derivatives

Where you can read as their conclusion:

“The use of credit derivatives has grown exponentially since the beginning of the decade. Transaction volumes have picked up from the occasional tens of millions of dollars to regular weekly volumes measured in hundreds of millions, if not billions, of dollars. Banks remain among the most active participants, but the end-user base is expanding rapidly to include a broad range of broker-dealers, institutional investors, money managers, hedge funds, insurers, and re-insurers, as well as corporates. Growth in participation and market volume is likely to continue at its current rapid pace, based on the unequivocal contribution credit derivatives are making to efficient risk management, rational credit pricing, and ultimately systemic liquidity. Credit derivatives can offer both the buyer and seller of risk considerable advantages over traditional alternatives and, both as an asset class and a risk management tool, represent an important innovation for global financial markets with the potential to revolutionise the way that credit risk is originated, distributed, measured, and managed.”

1 kommentar:

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