The Downside of Diversification

On the heels of today's news that investment bank Bear Stearns is on the ropes, we are again faced with the unintended -- and unwelcome -- consequences of developments that were once touted as unequivocally positive.

During the good times -- it's hard to believe that they only ended about a year ago -- proponents argued that Wall Street banks' involvement in all sorts of financing, trading and advisory activities engendered diversification benefits that only made those institutions and the financial system stronger.

Now that the credit bubble is bursting, however, the opposite seems true, as the problems at one firm radiate outward in every direction, spawning a plethora of aftershocks. In "Global Financial System Braced for Ripple Effect," the Financial Times details a range of potential Bear-related systemic vulnerabilities.

Bear Stearns is hardly Wall Street’s biggest investment bank but its travails have far-reaching consequences for the global financial system because of its crucial behind-the-scenes role in some of the world’s most troubled markets.

Bear is a significant underwriter of mortgage securities, an active trader of derivatives and leading financier of hedge funds.

Analysts said it was almost impossible to know what impact Bear’s problems would have on its clients, its counterparties and on other investors holding securities or derivatives that Bear is trying to liquidate.

“The ripples could be widely felt because Bear Stearns has so many points of contact with everyone else in the financial industry,” said Matt D’Amico, partner in the banking business at law firm Bryan Cave.

Evidence of bubbling contagion in the financial markets can be seen in the dramatic surge in the cost of credit insurance for global banks. Many banks have double-A credit ratings, but the price charged to insure their debt is more typical of lower-rated companies.

This breakdown in the credit derivative market illustrates the close ties of global finance. Insurance contracts on the banks are transacted in the over-the-counter (OTC) market, an arena created by the banks where they and their customers trade directly with each other.

The $45,000bn (€17.033bn, £22,342bn) of contracts in the credit default swaps market, in turn, is part of a bigger OTC derivatives market. It includes common financial instruments used by corporate treasurers and investors such as interest-rate swaps – with $347,000bn in notional outstanding contracts.

“Bear Stearns is counterparty to a huge number of OTC derivatives, and it is not just the unwinding of contracts with Bear that are a concern, but the ability of this market with relatively weak and untested infrastructure to handle such a shock,” said Karen Petrou, managing partner at Federal Financial Analytics.

Participants post collateral with each other when they trade derivatives, but it is unclear whether this will cover potential losses in the event of a crisis.

The effects of Bear Stearns are already felt in markets where the bank has tried to sell assets to meet its cash requirements.

A shortage of liquidity has forced investment banks and hedge funds to offload mortgage-backed securities and other assets at discount prices. Indeed, some rivals say Bear’s distress was evident on Thursday when it sold a large number of securities backed by Alt-A mortgages at distressed prices.

Wall Street investment banks are already expected to report significant additional losses on the mark-to-market valuations of securities when they report earnings next week.

Comments

[Scott F.]

There are Liars, and then there are Damn Liars.
How many other financial institutions are lying in this manner?

[Snappy Tom]

Since I saw the news this a.m about Bear Stearns I've had trouble making all the shop-worn hackneyed phraseology fit what is actually happening. Talk of shoes dropping, contagion, cascades, and metastasizing all simply fail when I try to get my head wrapped around what going on even as I type this. Until I remembered Hamburg. Hamburg in 1943. All the small fires caused by around-the-clock bombing have linked up and have become self-sustaining. Even people in shelters, untouched by the 1500 degree flames, were suffocated as the storm consumed everything.

Histrionic, perhaps. But remember the name of the blog where I'm graciously allowed to express these thoughts.

I've known that it was coming. Just like $1,000 gold. Well now they're here and I'm scared out of my wits because I know the Fed and its clones can't do a damn thing about ant of it. A contagion can be quarantined, dropping shoes dodged, cascades diverted and cancer radiated and poisoned with chemicals. This storm can only burn itself out. No firebreak can be made and there isn't enough flame retardant in the whole, wide world to stop it. How long it will take and the eventual toll is anyone's guess. I don't blame even the public perma-bears for trying to spin it as something less than what is actually happening. By the time the average American connects the dots between the price of groceries, gas, their house their quarterly statement from their 401k provider and the ominous financial soundbites on the evening news the flames will be in their yards.