Market Observations with Rob Kirby

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Underlying Assumptions: A Forensic Review

by Rob Kirby, Kirby Analytics. March 9, 2009

I’d like to take everyone on a little trip back in time – to May, 2003 – when Allan Yarish penned an article, Mark-to-market accounting undercuts banks' loan hedging, extolling the virtues of Credit Default Swaps. He did so methodically, by first identifying a problem or need:

“FAS [financial accounting standards] mandates that derivatives be recognized in the statement of financial condition as either assets or liabilities and are to be disclosed at fair value. Changes in fair value of the derivative instrument may be offset by changes in the value of the hedged asset. However, distortions that arise from differences between fair value accounting of derivative instruments and the accrual accounting valuations used in valuing bank loans makes hedge accounting difficult if not impossible to achieve.”

Remember folks, back in 2003, the Credit Default Swap market was in its infantile stages and was widely heralded as means for REDUCING RISK.

Source: Comptroller of the Currency

In explaining the role that Credit Derivatives were envisioned to play, Mr. Yarish reasoned,

“Money can't buy happiness, but risk managers like to think credit derivatives bring the next best thing-peace of mind in a volatile, unpredictable world. That's the argument for credit default swaps: They help manage the downside of bank lending--the risk of borrower default following an unforeseen change in financial condition.

He went on to add,

“The over-the-counter capital markets, the place where credit derivatives are originated and traded, have an enormous capacity for absorbing credit risk. As risk managers gained insight into the power of credit derivatives, banks became active users of credit derivatives to diversify loan portfolios and free up capital for additional lending. Credit default swaps today are widely used in portfolio risk management, according to the January 2003 Federal Reserve Senior Loan Officer Opinion Survey.”

But it’s not until one reads on – further down the first page of the article, that one begins to “pick up” on the faults in the UNDERLYING ASSUMPTIONS for these instruments to function properly:

A large part of the appeal of credit swaps is explained by their simplicity. Credit default swaps allow one party to "buy" protection from another party against potential losses in a specified loan or loan pool.”

The mistake here was the assumption that these contracts were “simple”. Clearly they were not:

Deutsche Bank Foreclosures Tossed Out of Ohio Federal Court – “They Own Nothing!”
November 12th, 2007
by Moe Bedard and Aaron Krowne

“….The Court’s amended General Order No. 2006-16 requires Plaintiff (Deutsche Bank) to submit an affidavit along with the complaint, which identifies Plaintiff as the original mortgage holder, or as an assignee, trustee or successor-interest.

Apparently Deutsche bank submitted several affidavits that claim that Deutsche was in fact the owner of the mortgage note, but none of these affidavits mention assignment or trust or successor interest.

Thus, the Judge ruled that in every instance, these submissions create a “conflict” and they “do not satisfy” the burden of demonstrating at the time of filing the complaint, that Deutsche Bank was in fact the “legal” note holder….”

The next “flying leap” of faith was the erroneous assumption that these instruments would remain liquid:

“Default swaps are easily traded in the secondary market, much like investment-grade bonds. Bank loans, on the other hand, are generally illiquid investments and are held to maturity. Five-year swap maturities trade most frequently, as this part of the credit curve typically has the highest liquidity.”

Upon reflection, I’m sure Mr. Yarish might choose to state that, “Default swaps formerly traded in the secondary market, much like investment-grade bonds.”

You see folks, the reality is that these instruments no longer trade – PERIOD! Except of course if you happen to be a “bag holder” that can be classified as a “BANK” – in which case you can “swap” your CDS toxic waste with the Federal Reserve for “good treasuries.”

As such we can see that these highly leveraged Credit Default Derivatives “morphed”, in a sense, and clearly became something other than what they were intended to be.

So Why Weren’t Curbs Put On The Proliferation Of Derivatives?

As the chart above illustrates, back in 2003 the market for interest rate derivatives [swaps] was already extremely well developed with J.P. Morgan’s outstanding notional position already exceeding 23 TRILLION:


Interest rate swaps with durations of 3 years or greater typically have a corresponding physical government bond trade embedded in them. Increasing outstanding notionals of interest rate swaps INCREASES aggregate demand for bonds – forcing rates DOWN.

In prior articles I have documented how these interest rate derivatives were utilized to give the Federal Reserve [through its chief agent J.P. Morgan] effective control of the “long end” of the interest rate curve – neutering usury – engineering long term interest rates DOWN.

Interest rate swaps were originally developed to [1] allow parties to exchange streams of interest payments for another party's stream of cash flows; [2] manage fixed or floating assets and liabilities and [3] to speculate - replicating unfunded bond exposures to profit from changes in interest rates. Growth in the first two of these activities are dependent on their being increased end-user-demand for these products – which there is not:


This means that the obscene, explosive growth in interest rate derivatives was all about speculation at best or interest rate suppression at its likely worst.

In this regard, utilizing forensic examination, we can see how the practical use for interest rate swaps morphed from its intended use [a hedging tool] to one of excessive speculation and interest rate suppression.

Federal Reserve Chairman Alan Greenspan was complicit and all too aware that Interest Rate Swaps had been utilized [predominantly via J.P. Morgan’s [now, Q3/08] 57 Trillion Interest Rate Derivatives Book] to “NEUTER” usury. As such, back in 2003, he did not want ANY regulation, intelligent discourse or peering eyes into what was really occurring in the derivatives complex.

In conclusion, any assumption that our systemically broken financial system is going to be miraculously cured or nursed back to health is likely misguided since the players that ‘gamed’ the system have yet to admit what they have done.

It’s hard to prescribe a cure to a malady you have not properly diagnosed.

Today’s Market

Overseas equity markets started the week exhibiting weakness with Japan’s Nikkei Index falling 87 points to 7,086. North American markets didn’t fare much better with the DOW giving up 79.90 points to 6,547, the NASDAQ falling 25.21 to 1,268.64 and the S & P losing 6.85 to close at 676.55. NYMEX crude oil futures gained 1.53 to 47.05 per barrel.

In the interest rate complex the benchmark 5 yr. gov’t bond finished the day at 1.88% while the 10 yr. bond ended the day at 2.88%.

On foreign exchange markets the U.S. Dollar Index gained .88 to 89.05.

Precious metals were crushed with COMEX gold futures losing 16.80 to 922.60 per ounce while COMEX silver futures took it on the chin for .40 to close at 12.98 per ounce. The XAU Index dropped 4.48 to 115.08 while the HUI Index lost 9.88 to close at 275.14.

On tap for tomorrow, at 10:00 a.m. Jan. Wholesale Inventory data is due, expected -1.1% versus prior -1.4%.

Wishing you all a pleasant evening and a prosperous trading week!

Rob Kirby

© 2009 Rob Kirby

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Rob Kirby | Proprietor, Kirby Analytics Newsletter - Proprietary Macroeconomic Research
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