I recently mentioned the derivative problems at Doral Financial could spill over into the larger market. Anytime the yield curve begins to change, the market has seen some spectacular blow ups in mortgage related derivatives. I’m guessing that Doral Financial was a warning shot across the bow of the market and that we’ll soon learn what has really been roiling the markets.
Last week, Raymond James’ incomparable Jeff Saut indicated that he though "something was wrong" in the markets but he couldn’t put his finger on it….
"Plainly, last week’s action was disconcerting, a lament we repeatedly used in all of our verbal strategy comments during the week. Consider this – we got an oversold reading as severe as those recorded at the October 2002, March 2003, and 2004 lows. We also got nearly a 13% collapse in the price of crude oil, and an 8.5% decline in interest rates (basis the 10-year T’bond), yet the bulls couldn’t even mount a tradable rally, causing one old Wall Street wag to say, “Something’s wrong!” And, that is why we conclude last Thursday’s comments by noting – all we can do is manage the risk, hold outsized positions of cash, grind our teeth, and wait for something to happen . . . and something big is going to happen. In those comments we also opined that we were getting the same feeling we had in August of 1998 when the stock market would not rally off of a similar oversold condition. Back then we suggested “something’s wrong . . . and we don’t know if it is another Russian debacle, a currency crisis, a terrorist event, or a hedge fund blow-up, but something is definitely wrong!” Not too many weeks later Long Term Capital Management “blew up” and the rest, as they say, is history. Unfortunately, given the collapse in energy, copper, commodities, et all, with all of the hedge fund money currently levered into those asset classes, if somebody made us hazard a guess, it would be that another large hedge fund is in trouble."
The list of possible problems is long and have already been partially digested by the market. AIG could have to write down $5 – $8 billion in capital which would put a "slight" crimp in it’s balance sheet. Fannie Mae management might be distracted from managing its bond portfolio because of the Congressional inquiry. Other mortgage originating banks could experience a derivative problem like Doral Financial. Another Askins Capital or Long-Term Capital Management could be forceably liquidating their portfolio. Or it could be a combination of all these factors weighing on the market.
The experience in 1993 and 1994, shows that derivative problems at banks often forewarn of larger problems at hedge funds. In late 1993, several banks reported problems in their mortgage portfolios as the yield curve began to flatten in anticipation of Fed tightenings. Then in 1994, when the Fed tightenings began to bite, the derivatives related blow up reached a peak. The highlight on the list is Askins Capital and Orange County which both blew up in April, 1994.
We can learn several things from the following list of derivative blow ups. 1) Derivatives are dangerous – the smart guy’s models often times disintegrate in the real world trading environment where statistical distribution curves are not always bell shaped; 2) Problems never appear until a long-term trend changes, indicating that many of these derivative strategies are simply weakly disguised trend following techniques; 3) the banks that sold these derivative products won’t be there for their customers when the products blow up – the market for many of these instruments is more illiquid than a $2 mln apartment in Cleveland, OH; 4) Problems at banks precede problems at hedge funds probably because banks have to mark their securities to market every quarter and report it to the public – hedge funds are much more secretive, and finally 5) By the time the public learns about what has been roiling the markets, its probably time to buy, not time to panic.
The following list is courtesy a Georgetown University study entitled "Derivative Events":
Date: 4/30/87
Institution: Merrill Lynch
Instrument: Mortgages
Problem: $180 million loss in four days by mispricing IPO of IO/PO strip.
8/20/89
Mass Financial
Bonds
Years of covered bond call writing and high current yield leave few bonds long and total return misses bond rally (also losses on some naked call writes)
10/2/89
Chemical Bank
Rates
Crash in swaption volatilities (13 to 7.5) and "special model" lead to $30 million loss.
1992
JP Morgan
mortgage
strips for $50 million, 9/29/94 reports loss of $200-300m led to Riskmetrics.
3/93
Salomon
mortgage
$250m, reported 8/10/93.
8/93-8/94
Medari
rates
$50m in structured notes
10/1993
Florida
mortgage
$99.6m for state treasury and League of Cities.
10/21/93
Louisiana Pension
Mortgages
ERS of $3 billion, since 1989 generating 20% annual returns. IOs and Inverse floaters broke back, and losses of $50 million. From Money Management Analytical Research (MMAR). (8/94 report is $25m)
10/27/93
AIG
Swaps
Howard Sossin-led Financial Products sub. breaks off over policy differences. Valuation differences lead to $90 million charge after $171 million gain in previous year. Issue on value of long-dated (30 year+) rate and FX swaps.
10/28/93
Hyperion 1999
Mortgages
Term Trust closed-end fund losses 30% of value and is subjected to class holders suit. Lewis Ranieri of Salomon MBS start managed.
11/1/93
Ohio municipalities
Mortgages
Bought interest-only mortgage strips as annuities. Falling rates brought huge pre-payment of mortgage principal and annuity lives fell drastically. (Many funds are underfunded nationally – 4/6/94.)
12/15/93
Banc One
Interest Rates
$318 million of $1.26 billion in earnings are derivative-based on $38 billion notional. Stock price drops and stays down.
1994
Community Hospital
CMO
of Springfield & Clark County, Ohio, $17 million in compensatory damages and $4.5 million in punitive damages against Kidder.
1994
Cargill
Mortgages
$ 100 million, 8/94.
4/1/94
Askin Capital
Rates
Massive mortgage-related "toxic waste" securities plummet in value, wiping our $600 million in managed fund’s equity. Firms dealing with Askin ravaged him on repurchase prices, 4/22/96, esp. Bear Stearns – Howie Rubin.
4/15/94
Orange Co., Cal.
Rates
On 19.5$ billion 2-5 year Treasury pool and 20% in derivatives, put up $140 million in "collateral calls."
5/12/94
Air Products
Rates
Levered swaps result in $60 million loss, and second $9 million write-off on standard swap positions, 5/17/94. 5/14/96 Air Products paid $67m of $107m 1994 losses.
6/8/94
Paine Webber
Mortgages
Paine-Webber adds $33 million to their Short-term U.S. Government Income Fund for mortgage-backed losses. 7/25/94 another $180 million needed beyond $88 million to date for year. 8/25/94 report to $268 million.
6/94
J.P. Morgan
$50 million trading loss on mortgage strips (traders fired).
8/16/94
Fund. Fam. of Funds
21% of $30.4 million fund in inverse-floaters loses 22.2%.
9/94
Paramount Comm.
Rates
Interest rate swaps lose $20 million.
7/13/94
Glaxo Holdings
Mortgages
$100 million loss predominantlyh on IOs, inverse-floaters and structured notes.
8/13/94
1st Federal
Rates
Michigan Large mortgage-backed positions hedged by swaps, $30 million.
9/23/94
Odessa College
Rates
Principal only strips and inverse floaters lose $10 million.
9/25/94
Sandusky cty, OH
Mortgages
$10 million loss, $5 million loss for Wyoming Shoshone reservation.
9/28/94
Vairocono Ltd.
Bonds
Highly levered position, with swap-option overlay loses $700 million. Following 1992 return of 55% and 1993 at 63%.
10/13/94
Cuyahoga cty, OH
Rev. repos
Loss estimates of $100 million on levered bond positions
8/98
LTCM
Levered trades
9/23 Fed rescue consortium of lending banks (1/98 4b in capital wiped out and have 3.65 b capital infusion.) Matuirty spread trades across Treasuries, credit spread reversion trades vs. Treasuries, foreign bonds including Russia and Dutch mortgages and large equity risk arb and long/short positions and total return swaps. UBS losses $680m the hedged sale of call options exercisable in seven years and an equity investment in the fund of $266 million
11/00
Lutheran -Missouri Synod
CMOs
1990 ok’d as fund advisor and assets grew $120m to $900m. Mid-90s, bought nearly $100 million of the mortgage derivatives. By the late 1990s, these securities accounted for 40% of the foundation’s bond portfolio. By 1/99, $40 million loss and closed out.
3/01
Sears
Rate swap
Funded some of credit card portfolio with variable rate debt and hedged with fixed rate swap. Rates moved against and unwound in 1997. With FAS 133, no longer amortising loss annually and after-tax charge is $236 ($389 pre-tax.)
7/01
Amex
Junk/CDO’s
American Express Financial Advisors unit, the Minneapolis-based money-management arm loses $400m in junk and CDO’s, collateralized-debt obligations. Packaged own deals and kept “toxic waste,” last 20% of payments.