Moon of Alabama Brecht quote
April 11, 2006

Where There Is Smoke ...

... there may not yet be fire.

But what makes the fire department think its time for some urgent retraining right now?

FINANCIAL regulators in all EU countries are to be asked today to prepare for the collapse of a big hedge fund or a similar sudden financial shock. EU finance ministers and central bankers, meeting in Vienna, were told that the collapse of a hedge fund could now destabilise European financial systems as well as the financial markets.
Be prepared for a crisis, EU regulators are told; London Times; April 08, 2006


Europe’s financial regulators have held a “war game” exercise, simulating a continent-wide financial crisis, amid fears they are ill-prepared to stop a problem in one country spreading across borders.

The exercise involved simulating the collapse of a big bank with operations in several large countries to see whether the European Central Bank, national central banks and finance ministries could work together to contain the crisis.

The report submitted to the Ecofin council identified a possible housing market crash, a bird flu pandemic and high oil prices as potential sources of risk, ...

... the report warned that hedge funds and credit derivatives were sources of concern “as related risks remain opaque and they have become extremely relevant in assessing financial stability both across borders and across all financial sectors”.
Europe simulates financial meltdown; FT; April 9, 2006

Posted by b on April 11, 2006 at 15:53 UTC | Permalink


Missed that. Nice catch. Didn't one of those crash and burn in the US recently?

Posted by: Colman | Apr 11 2006 16:03 utc | 1

Didn't one of those crash and burn in the US recently?

Not yet - and it doesn´t matter where it happens, the results will be seen everywhere. It's global finance ...

Posted by: b | Apr 11 2006 16:30 utc | 2

Anybody who hasn't read it might enjoy Michael Lewis's book Liars Poker. Came out just before the creditors in John Merriwether's hedge fund had to be bailed out, 5 or more years back.

Ought to be a cheapo at Abe Books.

Very good take on international paper traders and the culture.

Posted by: Groucho | Apr 11 2006 16:42 utc | 3

Funny, I read the ECB exercise report and got the impression that it slighted the usual suspects, hedge funds and derivatives issuers. The exercise seemed to focus on insolvency and disruption of payments systems -- pretty standard nightmares -- and the prescriptions seemed legalistic and procedural (how detailed to make the MOUs, how much to harmonize the regulations, what to communicate to whom.) I'm abashed to say I think that the Fed has done the best work on this. Their take is that in case of systemic disruption, netting and closeout will save the day. Still I fret (further down the thread). Others think I am being simplistic or perhaps neurotic. I hope so.

Posted by: psh | Apr 12 2006 2:09 utc | 4

A recent rundown on the growing danger of the credit derivative market by the widely cited HCM Market Letter written by Michael Lewitt:

As the financial markets increasingly move into the realm of computer models and derivative instruments, the ramifications for the global economy and the lives we lead are only beginning to be understood. Increasing amounts of the world's wealth are being traded indirectly rather than directly, which raises questions that governments, regulators and investors are only beginning to address. While governments still debate free trade in physical goods, the volume of intangible goods being traded without restraint grows at an exponential rate.

February 16, 2006, The Wall Street Journal "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.

What we have is a world-wide racetrack where bets are placed on the credit quality of major corporations. The bets' value far exceeds the actual debts of those corporations. No "house" is keeping track of the counterparties, or guaranteeing settlement. Whether these bets can be sorted out in the event of a major default is the $64 billion dollar question that the EU is worried about.

Posted by: PeeDee | Apr 12 2006 21:47 utc | 5

@psh, I'd like to know what you had to say, but you wrote it in shorthand sufficient only for those in the know. Would you take a moment to translate it for the financially illiterates @WhiskeyBar? Merci.

Posted by: jj | Apr 13 2006 0:54 utc | 6

@jj, damn, it sucks when jesus makes me speak in tongues, so sorry. Derivatives are contracts that pay off based on the value of specified assets: stocks, bonds, currencies, commodities, anything. Often they give you an option to buy or sell an asset at a specified price. Turns out you can extend someone an option, for a price, without losing your shirt, by holding some combination of other assets that offsets the risk you take. Financial engineering, they call it. Lucrative. Everybody's doing it. The web of options is so thick and tangled up that if one participant goes broke, everybody gets stuck with assets (or debts) that are prone to vary wildly. This is systemic risk, the chance of a cascade of bankruptcies due to some little hiccup.

To protect themselves, options holders have short-circuited bankruptcy law with provisions in their options contracts so they can close out their options in case someone defaults. Master contracts let them net out all of their transactions. That way, if they have a thousand options outstanding, fluctuating wildly, they can tally them up as a single number, asset or liability, and walk away. That's good for them. But instead of a court-directed insolvency that minimizes disruption and tries to save the troubled firm, you have lots of complex bilateral interactions that are difficult to predict. Maybe they conflict. Traders tell me they've got it covered, and they have from their own perspective, but the scariest risk is some emergent property of the market -- no one trader sees it coming -- like explosive oscillations in asset values or everybody pulling back at once and sucking the market dry of credit. You would hope that Europe gamed out some calamity like that; their options market is even more competitve than ours, by some measures.

Posted by: psh | Apr 13 2006 16:14 utc | 7

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