November 18, 2011

Derivatives Danger: Fears of Next Big Financial Crisis Won’t Go Away

Mobius says the exotic instruments continue to be misused, but he’s still in the market

People outside AIG building in New York. (Photo: AP) People outside AIG building in New York. (Photo: AP)

On a summer evening in 2007, a Goldman Sachs salesman sent a courtesy email to an AIG Financial Products exec that read: “Sorry to bother you on vacation. Margin call coming your way. Want to give you a heads up.”

“On what,” the brief email reply said 18 minutes later. The answer, one minute later: “20 bb [billion] of supersenior.”

The next day Goldman Sachs presented AIG with an invoice demanding $1.8 billion in collateral on $21 billion [the email mentioned $20 billion, but what’s a billion dollars among trading buds?] of AIG super-senior credit default swaps that Goldman owned.

According to the Financial Crisis Inquiry Commission Report (p. 244), from which this anecdote is taken, “AIG’s models showed there would be no defaults on any of the bond payments that AIG’s swaps insured.” But Goldman had its own model, showing losses of about 15% in the subprime mortgage bonds backing its CDS.

That little heads-up email likely ruined the AIG exec’s vacation. As for Goldman, it wisely purchased $100 million in new credit default swap contracts against the possibility of an AIG default on the same day it presented its demand for collateral.

So began the first, but not last, collateral call on AIG, leading up to the firm’s September 2008 insolvency, when it was inundated with collateral calls on CDS contracts it could not pay. The CDS contracts required the insurer to post collateral at exactly the time when losses made that impossible.

Now, three years later, some market participants are worried that a still opaque and largely unregulated financial derivatives market could trigger another financial crisis.

Mark MobiusMark Mobius (left), who oversees more than $40 billion in assets as executive chairman of Templeton Emerging Markets Group, gave voice to this concern in a May 2011 address at the Foreign Correspondents’ Club of Japan in Tokyo, saying: "There is definitely going to be another financial crisis around the corner because we haven't solved any of the things that caused the previous crisis.” The emerging markets fund manager cited an OTC derivatives market that continues to grow and now totals over $700 trillion.

Through a Franklin-Templeton spokeswoman, Mobius declined to comment further on this issue–beyond a commentary posted on his blog one month after his Tokyo remarks. In that post, he said: “What I am most concerned about is the use of derivatives as speculative tools or derivatives that involve high levels of leverage

where the investor did not adequately control the implied leverage and resulting market exposures and liabilities, such as companies that may use derivatives to ‘game’ commodity exposures…For example, an airline may start out using oil futures contracts to hedge the risk of a rise in the price of jet fuel, but may drift from this understandable hedging use into speculating on the price of oil ...”

Mobius added that the misuse of derivatives continues today. That said, as recently as this week, the Franklin-Templeton fund manager expressed optimism about current investment opportunities and downplayed risks emanating from Europe’s debt crisis on the global economy.

So Mobius says another crisis is coming but what he does is invest in attractively priced stocks. And that may be the wisest course of action; an investor can lose a lot of money being right about the next crisis too soon.

But fears of a 2008-style market crash are not likely to go away in the midst of a derivatives market 10 times the world’s GDP, whose risks AIG and many others so perilously misunderstood.

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