The column discusses the simple fact that because of a lack of disclosure market participants do not know what any individual firm's exposure to derivatives is. Without this information, it is impossible to assess the risk of any firm.
As a result, the markets are dependent on the financial regulators to properly analyze the risk of each firm's derivative exposure. However, what MF Global suggests, is that the regulators are not up to the task.
WHO are you going to believe — me, or your own lying eyes?
That old line from the Marx Brothers came to mind last week as MF Global, the brokerage firm run by Jon S. Corzine, was felled by over-the-top leverage and bad derivative bets on debt-weakened European countries.
Suddenly, all of those claims that American financial institutions have little to no exposure to Europe rang hollow.
You can understand why Wall Street wants to play down the threats from Europe....If market participants actually knew their exposures, they would not be able to gamble with derivatives.
Market participants would exert market discipline by increasing the banks' cost of funds and decreasing their access to funds to dissuade banks from taking on excessive risk.
But MF Global provides two lessons. The first is that our financial institutions are not impervious to Euro-shocks. The second is that when those problems reach our shores, they usually ride in on a wave of derivatives.
“The problems that we’ve had since the inception of the credit derivatives market have never been solved in any meaningful way,” said Janet Tavakoli, president of Tavakoli Structured Finance and an authority on these instruments. “How many times do we want to live through this?”
MF Global’s debacle was a result of complex swaps deals it had struck with trading partners.
While those partners owned the underlying assets — in this case, government debt — MF Global held the risk relating to both market price and default.
These arrangements at MF Global underscore two big problems in the credit derivatives market: risks that can be hidden from view, and risks that are not backed by adequate postings of collateral....Both of these problems are cured with detailed disclosure.
Detailed disclosure eliminates the ability to hide risks from view.
Market discipline, which results from being able to see the risks being taken, works to prevent financial firms from taking on more risk than they can absorb.
Consider an investment vehicle known as a credit-linked note. In these deals, investors buy a note issued by a special-purpose vehicle that contains a credit default swap referencing a debt issuer, like a government. That swap provides credit insurance to the party buying the protection, meaning that the holder of the note is responsible for losses in a so-called credit event, like a default.
Credit-linked notes are very popular and have been issued extensively by European banks. Many are governed by I.S.D.A. contracts, which define the terms of a credit event and require a ruling by the association on whether such an event has occurred.
But some deals have different definitions or contractual language overriding the I.S.D.A. agreement.
“The people writing these contracts may say, ‘I would like to be paid if there is a voluntary restructuring of debt, or if Greece goes back to the drachma, or if Greece goes to war with Cyprus,’ ” Ms. Tavakoli said. “I can declare a credit event where I am entitled to get paid if any of those events happen.”
Cash calls can also be generated by declines in the market price of the notes or increases in the cost of insuring the underlying sovereign debt issue, according to credit-linked note prospectuses.
The other party has to agree to these terms up front.
But, given the nature of these so-called bespoke deals, we don’t know the full extent of the insurance that investors have written on troubled nations or the circumstances under which the insurance must be paid. Neither do we know who may be facing severe collateral calls or demands for termination payments on the contracts.
When those collateral calls start coming, market values assigned to the securities that have been provided as backup can decline significantly. And when a company’s credit rating is downgraded, as MF Global’s was in late October, cash demands from skittish trading partners become even greater.
“At this late date we still don’t know the risks that are out there,” Ms. Tavakoli said. “This market is opaque, bespoke, and the regulators don’t know what they’re doing.”
At least regulators didn’t deem MF Global too big to fail. That’s a plus. But given the billions at stake in these markets, more transparency is needed about market participants, their financial soundness and their ability to withstand liquidity crises like the one that wiped out MF Global.
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