...back in DUSTOFF 26 and which my former friend, Paul, wished to correct was that the situation in regard to derivatives in general was worse than I was making it out to be for the following reasons. Paul points out (correctly) that all writers of derivatives are subject to a cash collateral mechanism which is considered to be a risk management tool. Counterparties establish an amount of unsecured risk (we risk guys call it exposure) that they are prepared to take on one another with--naturally--higher rated risks (AAA as opposed to Single-A) having a higher exposure limit. But, and it is here that Paul feels I was no clear enough--in the event of a credit downgrade either through a rating agency or THROUGH THE PRICE OF THE DERIVATIVE IN THE MARKET a counterparty has the right to lower its exposure (the credit limit) by demanding security by way of cash or cash equivalents as a matter of contract. Thus in a deteriorating credit environment a "run on the bank" is created. The more volatility the bigger the run and keep in mind that the creditworthiness of the player means little if the leverage it has taken on is greater than it's ability to provide cash coverage, which in extremist is obviously <51%. Look at it as capital: I continue to laugh at the concept of capital adequacy because when the world is ending that number is defined as >51%. To think otherwise is to adopt the same mistake as did the quants at AIG: "We know, based on our latest algorithm says, that it is..." No you don't sunshine. When the market is "no bid" it's 51%. Forget all else.
Former friend Paul also points out that if you are going to regulate derivatives you had better have all the players all around the world on the same page otherwise you don't have much. For better or for worse we find ourselves in a global marketplace but not in an equal global risk environment. Even with every choir singing from the same hymnal and all the transparency in the world in play through this marvelous concept of a global clearing house, it takes but one bad note or one clouded image. Consider: Greece was considered to be playing by the rules of the Eu until...ooops, it turns out that our friends at Goldman Sachs helped them through a bit of a rough patch by confusing a bit of over-leverage with a currency swap and look at the mess that has caused. Now I don't for a minute wish to suggest that all of this was done without a wink and a nod from all of Europe which perhaps to some folks surprise is not inhabited by masses of financial morons, but things can go south very quickly simply by a change in perception. Further, a financial book denominated in Euros, Yen or Sterling--not to mention a host of lesser traded currencies--jammed chocker-block full of U.S. dollar denominated esoteric real estate investments might, at a point in time, be considered less than prime as a result of currency fluctuations, credit assessments or market perceptions. There are a lot of players out there in our present interconnected space and they all deal with one another at one point in time. There are few places to hide and with today's information flow those don't last for long. In the good old days in the City if you wanted a dirty lunch with the gal from the office one just had to pop up to Islington: it's the Far Side of the Moon now, mate, and keep lookin' over your shoulder. Not so simple a world out there.
Anyway, this is just another way of saying if you want to guarantee a risk, guarantee the damn thing, like as I tried to teach in my management class; K.I.S.S.--keep it simple stupid. Or, as the old guy put it, "Oh, what tangled webs we weave when first we tryeth to deceive."
Thanks, Paul...bugger!
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