Post by joye1 on Sept 5, 2007 0:23:41 GMT -5
online.wsj.com/public/article/SB118679062506494753.html
WSJ: Complex Hedging Tactics Can't Trump Fear
Market's Flaws Surface
By ALISTAIR MACDONALD, IAN MCDONALD, HENNY SENDER and CARRICK MOLLENKAMP
August 11, 2007; Page A2
The past week's turmoil in stock and bond markets brought to light a mounting array of stresses in the global financial system as it struggles to adjust to disruptions once thought isolated to the subprime-mortgage market.
The biggest immediate issue -- a jump in short-term interest rates as banks became unwilling to make cash readily available to borrowers -- was met Friday by the Federal Reserve and the European Central Bank flooding markets with billions of dollars. The moves were joined by central banks in Japan, Australia and elsewhere.
Other stresses are popping up, too, many of them related to trades that involve derivatives -- complex financial instruments whose value can be hard to determine -- and to the activities of hedge funds.
At Citigroup Inc.'s credit-derivatives trading desk in London, volume has been so huge in credit-default swaps -- in which traders make bets on the likelihood of companies defaulting on bonds or loans -- that Citi can't keep up with orders. In the U.S., stock prices have been behaving bizarrely, with the shares of companies with seemingly poor prospects rallying. At the same time, U.S. securities regulators are probing the balance sheets of some U.S. investment banks to check whether they have been accurately recording the values of some derivative holdings.
The central banks' actions were aimed at bringing order to the frazzled markets. They helped calm the U.S., but not Europe, where fears persist that banks are overexposed to U.S. subprime-mortgage debt. The Dow Jones Industrial Average fell 31.14 to 13239.54, while trading in a range of about 225 points during the session. Yields on U.S. Treasury bonds fell, as investors turned to government bonds for safety. The pan-European Dow Jones Stoxx 600 index dropped 3.1% to 362.7.
Much of the recent turmoil is the result of fear. As investors have shunned risk, trading in some markets has dried up. But also behind the assortment of market glitches and unusual trading are massive changes in the global financial system that have taken place in the past decade.
Investment in hedge funds has boomed. Because they invest across a wide range of asset classes and regions, and take on debt to make their investments, these funds can transmit problems broadly. Hard-to-value derivatives also have boomed, but haven't been severely tested as now. Investors are learning that activities often taken for granted in established arenas such as the stock market -- knowing the price of an investment, for example -- can go bonkers in the world of derivatives.
Commercial-paper markets became caught up in some of these trends during the past week. Commercial paper, a staple investment for money-market mutual funds, are short-term loans typically issued by highly rated companies for less than a year. The market -- $2 trillion in the U.S. and nearly $1 trillion in Europe -- is considered one of the most easily traded and safest corners of the financial markets outside of U.S. government bonds.
But interest rates on commercial paper have risen as far and as fast as they did after the shock of the Sept. 11, 2001, terror attacks.
Behind the surge: Banks that typically lend to each other in this market were withholding loans to preserve money in case they needed to back up affiliates. Some European banks were facing credit squeezes because their affiliates might be exposed to U.S. subprime mortgages, bankers and traders say.
The commercial-paper problems hit Europe particularly hard. Investors worried that some European banks were exposed to U.S. subprime mortgages, particularly after German bank IKB Deutsche Industriebank AG disclosed on July 30 that its profits would be hurt by subprime exposure.
"It shows that there are so many interconnections today between different parts of the market that otherwise seem so disparate," says Eric Jacobson, director of fixed-income strategies at Chicago research firm Morningstar Inc.
The credit-default swap market also is a source of some concern. Investors increasingly turn to this market to make bets on the fortunes of companies, and to hedge themselves against the risk of a default. In the past few weeks, volume in indexes that track these derivatives has more than tripled, according to data from Deutsche Bank. By contrast, the so-called cash market, where the loans and bonds of individual companies exchange hands, has become almost totally frozen.
After trading a credit-default swap -- which banks exchange with investors, hedge funds and other financial institutions -- banks need to input the trade details into their internal computer systems and confirm the terms between parties. In 2005, regulators demanded that banks clean up huge backlogs in documenting these trades in this booming market, and they have made solid progress toward doing so.
The Federal Reserve Bank of New York demanded that banks clean up these backlogs in part because it worried dealers could lose track of who owes what to whom. Officials also worried that a backlog of unconfirmed trades could be called into question in times of market stress.
But Citi's London credit-derivatives office hasn't been inputting terms fast enough to keep up with high trading volumes in at least one of its markets, according to people familiar with the matter. As a result, a backlog of unprocessed trades has built again, they said.
"Based on industry metrics, our credit derivatives trade-confirmation and settlement activity is very much in line with the rest of the industry. We have heard no complaints from our clients," a Citigroup spokesman said.
As demand for credit derivatives increases, the market has become subject to other strains. In the face of huge price swings and a growing aversion to risk, it has become more difficult to execute trades. That is what traders refer to as liquidity risk; it may mean both dealers and hedge funds that thought they could get out of positions or hedge those same positions may be left with large exposures.
Indexes that track this market have swung widely in recent weeks. The volume of trades some dealers are willing to buy and sell have shrunk drastically, both dealers and their hedge-fund clients say. Both sides add that there is also a huge gap between the prices buyers say they will pay and the prices sellers say they will take. That further discourages orders.
Meanwhile, the Securities and Exchange Commission is worried about how the market is handling another kind of derivative called collateralized-debt obligations.
Securities regulators are checking the books at top Wall Street brokerage firms and banks to make sure they aren't hiding losses in the subprime-mortgage meltdown, said people familiar with the inquiry. The SEC is looking into whether Wall Street brokers are using consistent methods to calculate the value of subprime-mortgage assets in their own inventories, as well as assets held for customers such as hedge funds, these same people said. The concern is that the firms may not be marking down their inventory as aggressively enough.
The broader problem for the market is that trading in many of these instruments is so sparse, it has become increasingly difficult for investors and investment banks to put an accurate value on them.
--Kate Haywood contributed to this article.
Write to Alistair MacDonald at alistair.macdonald@wsj.com, Ian McDonald at ian.mcdonald@wsj.com, Henny Sender at henny.sender@wsj.com and Carrick Mollenkamp at carrick.mollenkamp@wsj.com
