Mover Mike

From the WSJ, GM Debt Poses Challenge To Derivatives Market

The car maker has about $30 billion in debt. Traders estimate more than $200 billion in credit derivatives are linked to GM. But because such derivatives don't trade on an exchange, nobody knows for certain how much credit-default swap protection has actually been written on GM. And nobody can say with confidence that they even know who is on the other side of the trades that they have entered into.

[...]

Four years ago, the derivatives market was a fraction of the size of the underlying corporate-bond market. Today, it is estimated at $12.5 trillion, more than twice the underlying market's size, and it continues to expand rapidly.

A report in 2002 from the Financial Policy Forum has a different number for the size of the derivative market.

Today the size of derivatives markets is estimated by the Bank of International Settlements to exceed $109 trillion in outstanding contracts and over $400 trillion in trading volume on derivatives exchanges.

Are you familiar with E. Gerald Corrigan, an executive with Goldman Sachs Group Inc.? Mr. Corrigan heads the Counterparty Risk Management Policy Group II, an industry group focused on the derivatives market.

Mr. Corrigan is organizing a symposium on March 1 to follow up on issues raised in a report published by the Counterparty Risk Management Policy Group II last July.

You can read the full report here.

The report is directed at initiatives that will further reduce the risks of systemic financial shocks and limit their damage when, rarely, but inevitably such shocks occur. (emphasis added)

There are three elements to a financial shock and these three elements don't happen sequentially but all at the same time.

First, the triggering event or events cause sharp and sudden declines in one or more classes of asset prices. The decline in asset prices is sufficiently steep to raise questions about the creditworthiness of major counterparties or institutions such that the analytical distinction between market risk and credit risk blurs as market risk and credit risk feed on each other.

Second, the combination of falling asset prices and the erosion of creditworthiness causes market participants to commence risk mitigation efforts such as position liquidations which - while perfectly reasonable at the micro level - add to macro pressures on asset prices wjich in turn trigger the initial evaporation of market liquidity for one or more classes of assets. The evaporation of asset liquidity aggravates both market and credit risk and begins to call into question balance sheet liquidity for some institutions. Investor position liquidations intensify these pressures.

Third, in these circumstances, once seemingly generous amounts of margin or collateral are rapidly called into question, thereby dramatically elevating credit concerns. The escalation of credit concerns further influences the defensive behavior of financial market participants, all of which acts to reinforce the cumulating the adverse market dynamics. Hence a financial crisis with systemic risks is at hand.

After a list of ten fundamentals about financial shocks and derivatives the Report makes a chilling point:

A central and recurring theme to every aspect of this Report is, in a word, complexity.

There are whole libraries devoted to identifying and managing risk in complex systems, but there is no accounting for the long tail effect. The shock that happens that is identified as having very little risk on a bell curve of risks. One doesn't need a bell curve to assess the risk of a financial shock.

Let us recall Fed Chairman Bernanke's comment yesterday in November, 2005 at the Hearing Regarding Ben Bernanke's Nomination to Be Chairman of the Board of Governors of the Federal Reserve in response to Sen. Sarbanes concerns about derivatives.

Bernanke:Nevertheless, broadly speaking, my understanding is that the hedge fund industry has become more sophisticated, more diverse, less leveraged and more flexible in the years since LTCM.

GM Derivatives Bernanke Sarbanes Mover Mike

Update: as to when the meeting between Sen Sarbanes and Bernanke took place.