The Snowball of Derivatives: The Specter of a Second Black Swan http://www.rgemonitor.com/globalmac...erivatives_the_specter_of_a_second_black_swan Ricardo Lago | Oct 21, 2009 Banking sector consolidation (via acquisition of failed banks) and the generalized bailout of bondholders, actions both promoted by governments, have aggravated the problems of âtoo big to failâ and âmoral hazardâ. Hence incentives for reckless behavior have actually heightened. So far there has been lots of talk within the G-20 and other forums but little action to tackle the problem at national and especially at transnational levels. As Nouriel Roubini and others have pointed out, one could argue that systemic risks have in fact increased relative to the pre-crisis period. A follow-up financial meltdown would be devastating. Governments should not only hope for the best but act swiftly to forestall the worst .The arrival of a Talebâs second black swan on stage would mean complete chaos. Governments should urgently agree on binding disclosure, oversight and enforcement of tighter rules on derivatives at the national and supra-national level. If only for the simple reason that now their fiscal and monetary leeway for future financial rescues is much diminished. After the first round of bail outs, debt to GDP levels of developed countries already exceed 100% of GDP and nobody really knows what the ratios would be if all guarantees and unfunded liabilities were to be brought above the line. Derivatives were the invisible 800-pound gorilla in the room. After accounting for them - even abstracting from counterparty risks - leverage ratios were a multiple of those reported in the books .It was the failure of Lehman Bros that drew the attention to the ultimate implications of this huge snowball rolling down the hill .In the eve of the bankruptcy of Lehman, the International Swap and Derivatives Association (ISDA), had to improvise an unprecedented trading session on Sunday, September 14th 2008 to enable market participants to carry out trades and offsets of derivatives; further, the effectiveness of the transactions was contingent on Lehman filing for bankruptcy by midnight. This was the first large-scale real life âWalrasian auctioneerâ - a fictional textbook Deus ex Machina who does not allow actual trades to take place until all contracts of market players are mutually consistent. And it was precisely this exercise of contingent trading that shed light on the magnitude of AIG financial troubles. The largest supermarket of default insurance was carrying in its books Credit Default Swaps marked at up to twice the values used by Lehman. All the ingredients for the perfect storm were in place. In order to forestall collapse, AIGâs creditors (including not only all major banks but also life insurance and retirement policy holders) had to be bailed out under the disguise of a de facto nationalization of AIG. One of the problems is that the snowball of swaps and derivatives has not shrunk much. The notional value of swaps and derivatives surveyed by the ISDA - by no means the real total which is unknown to us - amounts today to US$ 454 trillion or eight times the Worldâs GDP (just marginally lower than the value at the trigger of the crisis). This figure involves a gross credit exposure of US$ 26 billion or close to twice the GDP of the USA and a, more relevant, net credit exposure of US$ 4 trillion, a figure twice the total equity position of all US banks. All these figures are lower bounds; part of the problem is that we do not know what the real magnitude is. The central question is: will the G-20 (within BIS, IMF or any other) reach binding agreements on switching the lights on and enforcing an orderly unwinding and gradual shrinkage of the snowball of derivatives? Or will they procrastinate and let the snowball continue to roll downhill in the dark? The âAchilles heelâ of the international financial system continues to be the ocean of derivates, particularly those negotiated over-the counter (OTC), including but not limited to Credit Default Swaps (CDS). If the economic recovery holds there may not be any major hassle with orderly settlements. By contrast, if a double âdip hits us and its second leg is deep enough â however small the probability - then cash-strapped governments will have to choose between a second round of massive financial subsidies or else have creditors assume the losses and let banks fail. The first would likely lead to hyperinflation and the second to a collapse of the âhouse of cardsâ of the payments system and financial chaos, a 1930s style depression. In my view, the G-20 needs to move quickly on inter alia four specific reforms: Dealing with the flow. First, all new swaps and derivative contracts should, at a minimum, be traded and even issued through âclearing housesâ and, preferably, to the extent feasible traded on stock exchanges. This will deal with the âflow problemâ. Tight constraints need be imposed on OTC âconsenting adults" dealing in the dark, for at the end of the day âtax-payersâ end up being a party to the deal and thus should not be taken for granted (i.e. no taxation without representation.) Dealing with the stock. Second, as to the âstock problemâ, central banks should establish compulsory daily reporting of all derivative positions (counterparty, exposure, credit risk, collateral, etc) of their supervised institutions, including those carried out by their subsidiaries abroad. Central banks should be required to report weekly this information to the BIS, IMF, or any other suitable institution. Risk taking. Third, off-balance sheet operation should be tightened and swaps and derivative positions restricted as close as possible to risk management and hedging. The open positions of pure intermediaries in swaps and derivatives should be subject strict ceilings (i.e. no more glut of AIG âtype naked Credit Default Swaps). One case of success in limiting off-balance sheet operations was the restrictions to securitization introduced by the Bank of Spain years ago. Special resolution regime. Forth, the establishment of an automatic, special resolution regime affecting unsecured lenders of banks and other intermediaries .As Willem Buiter has put it, if the market value of a bankâs equity shrinks below a trigger then unsecured creditors should automatically receive a letter saying â congratulations as of today you have become a shareholder of Bank XYZ.â Warren Buffet was surely right on mark years ago when he said, âderivatives were financial weapons of mass destruction.âBut even Buffetâs own holding company, Berkshire Hathaway, carries a fair amount of derivatives, including the sale of long term puts on the US stock market index. The most naÃ¯ve and really incredible development of international public policy over the last ten years or so has been the Basel II guidelines for regulatory reform. It is hard to understand how on earth regulators could embark on a trip to outsource credit and market risk management to the supervised banks themselves. The so-called Advanced Internal Rating âbased Approach allowed banks to develop in-house risk management models to quantify their own capital adequacy requirements. And this proposal came after we all had the benefit of witnessing how in 1998, the very inventors of the options pricing formula - Nobel prize winners R. Merton and M. Schools - blew up with their own models the hedge-fund Long Term Capital Management. Clearly, Albert Einstein was not kidding when he said that: âTwo things are infinite: the universe and human stupidity; and I am not sure about the universeâ.