Chained together, for better for worse

September 17th, 2008

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As the drama unfolds in Wall Street over the past week, you may wonder what the big deal is. So what if Lehamn Brothers collapses? So what if AIG and Washinton Mutual go down the grave too. Why are the financial markets, central bankers and governments all over the world so jumpy about all these failures?

One word to explain it: contagion.

As we explained back in Financial system?messy, tangled ball of yarn,

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?

To give you a more concrete idea of what’s going on in the financial system, consider this hypothetical scenario from this excellent article, The Ultimate Wall Street Nightmare:

Here’s the great dilemma: The tangled web of bets and debts linking each of these giant players to the other is so complex and so difficult to unravel, it may be impossible for the Fed to protect the financial system from paralysis if just one major player defaults. And if Lehman is not that player, the next one will be.

To understand why, put yourself in the shoes of a senior derivatives trader at a big firm like Morgan Stanley (which has $7.1 trillion in derivatives on its books and about $10 billion in capital).

Let’s say you’re personally responsible for $500 billion in derivatives contracts with Bank A, essentially betting that interest rates will decline.

By itself, that would be a huge risk. But you’re not worried because you have a similar bet with Bank B that interest rates will go up.

It’s like playing roulette, betting on both black and red at the same time. One bet cancels the other, and you figure you can’t lose.
Here’s what happens next …

  • Interest rates go up, reflecting a 2% decline in bond prices.
  • You lose your bet with Bank A.
  • But, simultaneously, you win your bet with Bank B.
    So, in normal circumstances, you’d just take the winnings from one to pay off the losses with the other ? a non-event.

But here’s where the whole scheme blows up and the drama begins: Bank B suffers large mortgage-related losses. It runs out of capital. It can’t raise additional capital from investors. So it can’t pay off its bet. Suddenly and unexpectedly …

You’re on the hook for your losing bet.
But you can’t collect on your winning bet.

You grab a calculator to estimate the damage. But you don’t need one ? 2% of $500 billion is $10 billion. Simple.

Bottom line: In what appeared to be an everyday, supposedly “normal” set of transactions … in a market that has moved by a meager 2% … you’ve just suffered a loss of ten billion dollars, wiping out all of your firm’s capital. Now, you can’t pay off your bet with Bank A ? or any other losing bet, for that matter.

Bank A, thrown into a similar predicament, defaults on its bets with Bank C, which, in turn, defaults on bets with Bank D. Bank D has bets with you as well … it defaults on every single one … and it throws your firm even deeper into
the hole.

During the 2nd century AD, just before the official end of the Han Dynasty, China was broken up into warlord’s fiefdoms. One warlord, Cao Cao, was amassing a large navy to defeat the combined forces of Liu Bei and Sun Quan. Cao Cao, used a misguided strategy to protect his navy from being scattered by chaining the ships together. His enemies launched an incendiary attack. Because his ships were chained together, fire spread from one ship to another and none of them could scatter to escape. The result: a massive defeat that paved the way for China to be split into 3 kingdoms.

This is the same for today’s financial system. They are chained together by derivatives.

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