Financial system?messy, tangled ball of yarn

August 30th, 2007

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Just how horrible is the current rot in the global financial system? Frankly speaking, no one really knows. Not even central bankers. As the Reserve Bank of Australia (RBA)’s March 2007 Financial Stability Review said,

Rapid growth in the use of credit derivatives is also posing financial regulators with a number of issues relating to transparency (Graph 11). In some cases, the balance sheet data received from financial institutions are becoming less meaningful, as credit exposures are taken on or divested through derivatives. The growth of credit derivatives markets has also meant that it is less clear where the credit risk actually resides, and how those holding this risk will react in a less benign environment.

Back in January this year, in Prepare for asset repricing, warns Trichet, we quoted the warning by Trichet, the president of the European Union central bank, that

There is now such creativity of new and very sophisticated financial instruments . . . that we don?t know fully where the risks are located… We are trying to understand what is going on?but it is a big, big challenge.

As Bill Gross, the founder and chief investment officer of PIMCO, the world’s largest bond mutual fund., said in Why We Need a Housing Rescue,

Goodness knows it’s not easy to understand the maze of financial structures that appear to be unwinding. They were created by wizards of complexity: youthful financial engineers trained to exploit cheap money and leverage and who have, until the past few weeks, never known the sting of the market’s lash.

Although has been estimated that the amount of bad debt (derived from sub-prime loans gone bad) losses could amount from US$100 billion to US$200 billion, nobody knows where they are. It may be possible that your pension fund may be sitting on a time-bomb and still not aware of it!

All these ?wonders? of the modern financial system, namely debt and derivatives, enabled the creation of a complex tangled mess of linkages between participants (e.g. financial institutions, funds, investors, banks, etc). The former (debt) allows the use of leverage while the latter (derivatives) allows risks to be transferred like a hot potato from one hand to the other. That sounds good, does it? But what if the derivative that you used to hedge your risks become useless because the counter-party of that derivative could not honour its obligation? In that case, you may not be able to honour your obligation against another party. Imagine repeating this scenario countless times over, forming a yarn of complex entanglements. What if a small section of the yarn catches fire? What will happen to the yarn as a whole?

There are those who said that there is so much liquidity in the world that asset prices can never fall. We suspect they are wrong. If liquidity is largely made up of debt and derivatives, it is very possible for them to disappear (see Spectre of deflation).