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   Non-TechDerivatives: Darth Vader's Revenge

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From: Worswick4/18/2020 10:28:40 AM
2 Recommendations   of 2789
Well it took a bit of time .... 22 and 3/4's of a year to get bank-based financial "derivatives" baked to perfection.

Since I started this blog 8/31/1998 I can't imagine the tens of thousands of financial operatives who put their backs to building this extraordinary mountain of $640 + trillion in financial derivatives.

Good work lads. Well done! Your efforts will possible remain unique in poisoning the lives of a whole planet.

Best to you, my patient Revenger's .


"Lethal For Bullion Banks" - The Looming $600 Trillion Derivatives Crisis

by Tyler DurdenSat, 04/18/2020 Alasdair Macleod via,

See for the charts herein embedded in this article:

The powerful forces of bank credit contraction are at the heart of a rapidly evolving financial crisis in global derivatives, whose gross value is over $600 trillion; an unimaginable sum. Central banks are on course to destroy their currencies through unlimited monetary expansion, lethal for bullion banks with fractionally reserved unallocated gold accounts, while being dramatically short of Comex futures.

This article explains the dynamics behind the current crisis in precious metal derivatives, and why it is the observable part of a wider derivative catastrophe that is caught in the tension between contracting bank credit and infinite monetary inflation.


One of the scares at the time of the Lehman crisis was that insolvent counterparties risked collapsing the whole over-the-counter derivative complex. It was for this reason that AIG, a non-bank originator of many derivative contracts, had to be bailed out by the Fed. By a mixture of good judgement and fortune a derivative crisis was averted, and by consolidating some of the outstanding positions, the gross value of OTC derivatives was subsequently reduced.

According to the Bank for International Settlements, in mid-June last year all global OTC contracts outstanding were still unimaginably large at $640 trillion, a massive sum in anyone’s book. It is unlikely to have changed much by today. But in bank balance sheets only a net figure is usually shown, and you have to search the notes to financial statements to find evidence of gross exposure. It is the gross that matters, because each contract bears counterparty risk, sometimes involving several parties, and derivative payment failures could make the payment failures now evident in disrupted industrial supply chains look like small beer.

Deutsche Bank’s 2019 balance sheet gives us an excellent example of how they are accounted for in commercial banks. It conceals derivative exposure under the headings “Trading assets” and “Trading liabilities” on the balance sheet. You have to go into the notes to discover that under Trading assets, derivative financial instruments total €80.848bn, and under Trading liabilities, derivative financial instruments total €81.910bn, a difference of €1.062bn This is relatively trivial for a bank with a balance sheet of €777bn.

But wait, there is another table that breaks derivative exposure down even further into categories, and it turns out the earlier figures are consolidated totals. The true total of OTC derivatives and exchange traded derivatives to which the bank is exposed is €37.121 trillion. That is nearly thirty-five thousand times the €1.062bn netted difference in the balance sheet. And when you bear in mind that valuing OTC derivatives is somewhat subjective, or as the cynics say, mark to myth, it invalidates the valuation exercise.

Clearly, by taking the mildest of a positive approach to derivatives held as assets, and a slightly more conservative approach to valuing derivatives on the liabilities side, that 35,000:1 leverage at the balance sheet level can make an enormous difference.

Now let us take our imagination a little further. A large number of these derivatives will have commercial entities as counterparties, businesses that have been shut down by the coronavirus since the balance sheet date. With the German economy already heading into recession before the coronavirus closed down much of the global economy, Deutsche Bank’s risk of losses arising from its derivative position could turn out to be in the trillions, not the one billion netted difference shown on the balance sheet.

Not only is there the emergence of counterparty failures to deal with, but there are ever-changing fair values, which will particularly reflect interest rate spreads increasing for Deutsche Bank’s €30.25 trillion interest rate-linked derivatives. We cannot know whether it is net positive or negative for shareholders. And with balance sheet gearing of assets 22 times larger than share capital very little change could wipe them out.

Deutsche Bank is not alone in presenting derivative risk in this manner: it is the elephant in many bank boardrooms. As a weak link, Deutsche is a relevant illustration of risks in the banking system. Since the Lehman crisis, its senior management has been on the back foot, retreating from businesses they could neither control nor understand. They have also made very public mistakes in precious metals, which is our next topic.

Editorially, I am putting a line break in this article as gold derivatives can possibly be “ring fenced” from other financial derivatives by the government financial “authorities”.


Gold derivatives in crisis

While a struggling bank like Deutsche provides us with a laboratory experiment for how a derivative virus can kill a bank, we are now seeing it kill off bullion banks in real time. A rising gold price, out of the control normally imposed by expandable derivatives, has effectively gone bid only in any size. We are told this is due to COVID-19 shutting mines and refineries and disrupting logistics, and so is purely temporary. The LBMA and CME which runs Comex have been issuing calming statements and even announced the introduction of a new 400-ounce gold futures contract alleged to ease the supply shortage.

In short, the gold derivative establishment is panicking. The swaps position on Comex shows why.

With their net short position in very dangerous territory, Comex swaps are badly wrongfooted at a time when the Fed and other central banks have announced unlimited monetary inflation, signalling a paradigm shift in the relationship between sound and unsound money. For ease of reference and to understand their relevance, a swap dealer is defined by the Commodity Futures Trading Commission, which collates the figures, as follows:

An entity that deals primarily in swaps for a commodity and uses the futures markets to manage or hedge risks associated with those swap transactions. The swap dealer’s counterparties may be speculative traders, like hedge funds, or traditional commercial clients that are managing risk arising from their dealings in the physical commodity.

Therefore, a swap dealer is one that operates across derivative markets, and typically will trade in London forwards as well as on Comex. In a nutshell, it describes a bullion bank’s trading desk.

In a further piece of disinformation this week, Jeff Christian, head of CPM Group, in an obviously staged interview for MacroVoices claimed that traders in London were forced by their banks to cover trading risk in the futures market as a condition of their funding. The implication was shorts on Comex are matched to longs in London’s forward market and therefore not a problem. This may be true of an independent trader looking for arbitrage opportunities between markets but is not how it works in a bank.

The mechanics of gold derivative trading

A bank which has bullion business will almost certainly have a trading desk and be a member of the LBMA. Look at it from a banker’s point of view. The bank has business flows in gold, which requires access to the market and a dealing capability. He will employ one or more gold traders with acknowledged expertise to manage the desk. As a profit centre and because a skilled trader will require it, he will give the desk discretionary trading limits and monthly or quarterly profit targets. Part of the deal with the desk is profits will be struck net of the cost of funding the book, usually a reference to Libor, which is effectively the marginal cost to the bank of expanding its credit to back the dealers’ positions.

When the gold desk has established a profitable track record, the banker will be eager to raise the trading desk’s position limits. For bullion banking this has been going on for years, and while individual trading desks come and go, traders now have a large degree of dealing autonomy. It is not, as Mr Christian misinforms us, just a covered arbitrage business between forwards in London and futures in America.

The LBMA lists twelve market makers, all of which are well-known banks. There are thirty-one other banks, some of which run trading desks which take positions. It is worth noting that dealing in gold is normally one of many banking and trading activities undertaken by an LBMA member bank, including forex trading with which this activity is very similar. All of them are funded by the expansion of bank credit, which is the point of having a banking licence.

Turning to Comex, according to CTFC data there are a maximum of 28 swap dealers which recently have been active in gold futures, either with long or short positions. These numbers tie in nicely with the likely number of trading desks and designated market makers in the banks which are LBMA members.

An LBMA member bank will have physical bullion business and is likely to offer allocated and unallocated accounts to customers. Since the point of banking is to operate a fractional reserve-based customer service, a bullion bank discourages allocated (custodial) accounts, usually by making them an expensive way for customers to hold bullion. Unallocated accounts, which under fractional reserve banking will be a multiple of gold or gold derivatives in the possession of the bank, becomes the bank’s standard customer offering.

One of the benefits of LBMA membership is it gives a bullion bank access to paper markets, so that it can replace physical bullion held against unallocated client accounts with long positions for forward settlement, positions that can be rolled and rolled without ever having to take delivery. Another benefit is access to leased gold from central banks which store bullion in the Bank of England’s vault.

One can begin to see why dealings between LBMA members are so significant, recently hitting 60 million ounces a day, the equivalent of 1,866 tonnes. This represents dealings between LBMA members only and excludes dealings between a member and a non-member. In the distant past they were included in LBMA estimates, which inflated the numbers even further by a factor of about five times.

All this is done on minimum bullion liquidity, which when you take away central bank gold, physical ETF custodial bullion, as well as bullion owned or allocated to miscellaneous institutions, family offices and private individuals stored in London bullion vaults, is not the 8,326 tonnes claimed in a recent LBMA press release designed to calm the markets, but is almost certainly significantly less than a thousand tonnes.

Clearly, running long positions for forward settlement has become a substitute for backing unallocated accounts with a fractional amount of physical metal. While the trading books in London keep the plates spinning in their dangerously geared operation, the profit opportunities on Comex have become a separate matter instead of just a hedging facility.

Officially described as speculators, but better described as suckers, gold and silver futures are the medium for a repeating cycle whereby market makers supply them contracts by drawing on the ability of their banks to create bank credit out of thin air. Once the suckers run out of buying power, the market makers pull the rug out from under them, taking out their stop-loss points. It has been an immensely profitable exercise for swap dealers.

Fortunately for swap dealers, the suckers have short memories. Until last year, it was a frequently repeated exercise, leading to a blasé attitude. Corruption among traders had become rife and they began to be caught spoofing and rigging the fix against bank customers. Dealers were sacked, fined and jailed. Deutsche Bank were fined and forced out of the twice-daily fix. A JPMorgan trader pleaded guilty last August to manipulating the precious metals markets for nine years. Another with the same firm had pleaded guilty the previous October. In the past five years federal prosecutors have brought twelve spoofing cases against sixteen defendants, most pleading guilty.

This corruption is typical of end-of-cycle behaviour, when the derivative ringmasters in precious metals believe they have risen above the law. The point behind the current crisis unfolding in the gold derivative markets is the scam has fully run its course, and the bankers in charge of bullion desks will be increasingly concerned of the reputational damage.

How the ending of the gold derivative scam started

In the past, bullion banks always managed to put a lid on open interest, returning it from an overbought 600,000 contracts to under 400,000 contracts, in the process getting an even book or exceptionally going long, ready for the next pump-and-dump cycle. But then something changed. Last year, the pump-and-dump schemes of the bullion banks’ trading desks went awry, with open interest rocketing to nearly 800,000 contracts by January this year. After several failed attempts, in June 2019 gold had broken above $1350, which encouraged the speculators to chase the price up even further. The interest rate outlook then softened along with the global economy, and by early September, with open interest threatening to rise above the historically high 650,000 level, the Fed was forced to inject inflationary liquidity into the US banking system through repos. At its peak on 23 January 2020, the sum of all short positions on Comex was the equivalent of 2,488 tonnes of gold, worth $125bn. The suckers were finally breaking the banks, who held the bulk of the shorts. This can be seen in the chart below of Comex open interest:

It was imperative that the position be brought under control, and accordingly, it appears that central banks, presumably at the behest of the Bank of England, arranged for gold to be leased to the bullion banks to ease liquidity pressures. And then trading desks were hit by a perfect storm.

The coronavirus put large swathes of the global economy into lockdown, disrupting payment chains in industrial production. This meant that formerly solvent businesses now face collapse and are turning en masse to their banks for liquidity. The bankers’ natural instinct is no longer the pursuit of profit, but fear of losses, and they now have an overwhelming desire to contract outstanding bank credit. In a panic, the Fed cut the Fed funds rate to the zero bound and promised unlimited liquidity support in a desperate attempt to avoid a deflationary spiral. Meanwhile, our swaps traders in gold futures were caught record short, the worst possible position for them given the evolving situation.

The coup de grâce has now come from their banking superiors. Despite the efforts of the Fed to persuade them otherwise, bankers in their lending have become strongly risk-averse and know they will be forced to commit bank credit to failing corporations against their instincts. For this reason, they are taking every opportunity to reduce their balance sheet exposure to other activities. One of the first divisions to suffer is bound to be bullion bank desks running short positions, synthetic in London and actual on Comex, which are wholly inappropriate at a time of massive monetary inflation.

It is this last pressure that has led to an unusual combination of collapsed open interest, shown in the chart above, and rising gold prices, accompanied by a persistent premium of $40 or more over the spot price in London. Clearly, there is good reason for the LBMA and the CME to panic. If the gold price rises much further, there will be bullion desks, managing shorts on Comex and fractionally reserved positions in London, at risk of bankrupting their employers.

The Comex contract, which anchors itself to physical gold through the option of physical delivery at expiry, will face enormous challenges when the active June contract expires at the end of next month. At expiry, the speculators have a chance to obtain delivery. Normally, when the spot price is lower than the future, only the insane would insist on delivery at the higher price. But with very low availability of bullion and price premiums for delayed delivery common, London is being rapidly drained of physical liquidity as well. It is like a good old-fashioned one-two boxing combination: first the Comex market is delivered a body-blow, and then the LBMA gets an uppercut.

Many central banks who have stored their earmarked gold at the Bank of England will be unhappy as well, having leased their gold in the expectation it would stabilise the bullion market. They will not do it again for an interesting reason: gold leasing rates have turned strongly negative, with the two-month rate currently minus 3.7%. No sensible entity is going to pay a lessor to lease its gold and will want leased gold returned instead. Therefore, the availability of gold for leasing is now cut off and gold already leased will need to be returned if delivered to the lessors, or unencumbered if it remained in the Bank of England’s vaults as is the normal leasing practice.

Gold liquidity in London will then disappear entirely, at which point those with a claim to custodial gold will hope that their property rights remain protected.

Broader implications of the failure of gold derivatives

This article has gone into some detail why Comex and the LBMA face their current difficulties, and why liquidity is vanishing. For any bank with large unallocated gold liabilities, bearing in mind they are fractionally reserved mostly against derivatives instead of bullion, these problems are likely to lead to their withdrawal from the market. ABN-Amro is already reported to have closed its customers’ accounts, having forced them to sell positions, and other banks will surely follow.

The gold derivative market is probably the largest foreign exchange cross after the US dollar euro. But it is also the most fundamental of all monetary exchange markets. The relationship was famously captured in John Exter’s inverse pyramid, which showed how the world’s credit obligations were all supported on a diminishingly small apex of gold.

The liquidity pressures that result from banks trying to reduce their balance sheets also affects other derivative markets, and from our discourse on Deutsche Bank’s balance sheet, we can see that the whole banking system is in a very precarious position with respect to derivatives. While we survived the Lehman crisis with only one investment bank failing, the collapse of industrial production of goods and services due to lockdowns to control the spread of the coronavirus will almost certainly lead to multiple bank failures. Bankers are staring into an abyss.

For central banks, monetary inflation is everywhere the solution. Bank rescues, payment chain failures, the furloughing of millions of employees, helicopter money to bail out whole populations, money to bail out governments, money to support all categories of financial assets: the list is endless in scope and infinite in quantity. The survival of the global financial system is at stake. If it survives, state-issued money will have been destroyed. But then what is the point of owning financial assets valued in valueless currency?

While this process of monetary destruction would have reasonably been expected to evolve over time, the coronavirus has accelerated it. The fate of the $640 trillion derivative mountain recorded by the Bank for International Settlements is sealed and will be settled through bank bankruptcies and state-directed elimination.

In observing the train wreck that is precious metal derivative markets, we are at Act 1 Scene 1 of a rapidly-evolving and dramatic derivatives tragedy.

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To: Worswick who wrote (2730)4/18/2020 11:52:26 AM
From: ggersh
1 Recommendation   of 2789
Instead of "thousands" I might narrow that down to the "terrible three"

oh and we were warned

Brooksley Born is best known as the sole regulator in the Clinton administration who attempted to regulate derivatives and became the target of bullying by then Treasury Secretary Robert Rubin, his enforcer, Larry Summers, and Fed Chair Alan Greenspan. Frontline aired an expose on the guts Born summoned to stand up to the Wall Street enablers’ cartel. In the end, of course, Wall Street had its way and derivatives remained unregulated. Born resigned her post.

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To: Worswick who wrote (2730)4/18/2020 11:55:35 AM
From: ggersh
   of 2789
Instead of "thousands" I might narrow that down to the "terrible three"

oh and we were warned

Brooksley Born is best known as the sole regulator in the Clinton administration who attempted to regulate derivatives and became the target of bullying by then Treasury Secretary Robert Rubin, his enforcer, Larry Summers, and Fed Chair Alan Greenspan. Frontline aired an expose on the guts Born summoned to stand up to the Wall Street enablers’ cartel. In the end, of course, Wall Street had its way and derivatives remained unregulated. Born resigned her post.

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To: Worswick who wrote (2730)4/19/2020 3:46:57 PM
From: The Ox
   of 2789
It would seem to me that all of these issues will surface down the road but in the short term, they may be "papered over" by the FED's (and other central banks) current approach.

Were the banks forced to directly address diminishing liquidity in several key areas, we'd see more "blown up" entities. In the same way banks are being forced to loan money to businesses that should not have money loaned to them, the FED is spreading enough money around to push out some of these disasters, that are just waiting to happen.

Unless we get a major domino falling that catches the powers that be totally off guard, we may be wise to expect the train wrecks to occur farther down the track. They've greased the squeaky wheels but at some point they'll run out of grease or simply miss a wheel that wasn't squeaking loud enough.

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From: The Ox4/22/2020 7:47:06 AM
1 Recommendation   of 2789
Negative Oil Prices, From the Folks Who Brought You the Financial Crisis

The financial world has been turned upside down by extraordinary events in recent years. First there were negative interest rates, something that had never happened in 5,000 years of recorded history. Now it’s negative oil prices , a phenomenon that sparked headlines Monday far beyond financial news.

There are important differences between the two, however. Negative interest rates were imposed by central banks in Europe and Japan as part of their conduct of monetary policy. Oil, by contrast, trades in a relatively free market that, once again, is proving to be resistant to control by government-run cartels.

Perhaps more significantly, the spectacle of oil prices falling below zero also demonstrates the outsize impact that various derivative financial products can play in setting the price in markets. And it further serves as a reminder of the observation of the late Paul Volcker —the former Federal Reserve chairman and the greatest central banker of our time—that he saw just one financial innovation of true economic value: the automated teller machine.

The U.S. benchmark crude for May delivery fell Monday to a settlement price of minus $37.63 per barrel. The reason that sellers would pay buyers to take oil off their hands is that there was literally no place to store it. <snip>

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From: Worswick4/23/2020 12:18:48 PM
2 Recommendations   of 2789
Well here it goes .... in the meantime before I get into this BELOW....







First BNP, Now SocGen: French Banks Suffer Huge Losses As Derivative Trade Blows Up Tyler Durden Thu, 04/23/2020

Three things are guaranteed: death, taxes and French banks, the world's so-called "derivative gurus", losing boatloads of money any time the VIX spikes.

As a reminder, two weeks ago we reported that BNP Paribas, the largest French bank, lost hundreds of millions of dollars on complex stock trades as markets crashed in March. To exactly nobody's surprise, traders at the Paris-based bank, which together with its biggest competitor SocGen, had long carved out a niche in "sophisticated" derivative trades - which work great as long as the market levitates unperturbed and suffer massive losses once the VIX spikes - lost an estimated €200 on equity derivatives once the market tumbled.

According to Bloomberg, the trades that went awry included dividend futures and structured products. As we noted, BNP lost about 100 million euros on structured products, ostensibly by taking the other side of trades they sold to retail investors across Japan and South Korea; the trades were linked to baskets of stocks and other assets. The bank also lost about 100 million euros on dividend futures, with losses surging at one point to about 300 million euros before improving.

Fast forward to today, when the axiom that French banks always blow up when volatility jumps, was confirmed again, after Bloomberg reported that the "other" French bank, Societe Generale, also lost hundreds of millions of euros on stock trades during the market turmoil triggered by the coronavirus pandemic, and just like BNP, the bulk of this loss was also on dividend futures.

The losses in the equity unit - which amounted between €150 million and €200 million - took place in the first quarter and before April’s oil rout, and are likely to be cushioned by the bank’s performance in fixed income and currencies, as the global markets unit at Societe Generale saw trading volumes three to four times higher than usual in March across equities and FICC the people said. Unless of course the bank somehow manages to also lose money on soaring flow trading as well.

BNP and SocGen have emerged as the biggest players in trading of dividend futures which have tumbled since the emergence of the deadly coronavirus as firms around the world suspend their shareholder friendly actions.

In an April 14 note, JPMorgan analysts - who warned that French banks are the most exposed to such funky derivative products - estimated that SocGen lost as much as €300 million euros in the first quarter on “dividend positions in equity derivatives." They were almost spot on.

Chief Executive Officer Frederic Oudea said in a February earnings call that equity derivatives contributed to a 9% rise in revenues at the equities business in the fourth quarter; in a few days we will find out what their contribution was to the first quarter loss. SocGen is ranked third globally for equity derivatives revenues, according to data from Coalition.

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To: Worswick who wrote (2735)4/23/2020 1:10:20 PM
From: ggersh
   of 2789
Clark this might be a better representation of what is actually happening, IMO

besides the fact that tRump believes a high stock markit price is a

reflection of his greatness, the stock markit rise has been a scam

the video to watch is at the end of the article, regardless this time it
is different

French Banks, meh? Hedge Funds and PE got crushed, can't/won't pay their debt??

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From: ggersh4/27/2020 11:39:24 AM
   of 2789
Nice watch guys!

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From: Worswick5/12/2020 9:00:50 AM
6 Recommendations   of 2789
To you all .... the mildest of the synthetics goes down ....

" lipstick on a pig" ... a many multi billion $ pig! $1.2 trillion or more.....

Modern Alchemy: This Is How Wall Street Converts A Portfolio Of 96% Junk Loans Into 87% Investment Grade Bonds

by Tyler Durden

Mon, 05/11/2020 - 21:05

There is a reason why so much attention has fallen on Collateralized Loan Obligations since the March market crash, and it has more to do than merely why an AAA-rated CLO recently breached its overcollateralization test, something which as we first reported last month was previously viewed as impossible, or why as many as 1-in-3 CLOa are expected to limit payouts to holders of the riskiest and juiciest, tranches and after that impair the less risky tranches as well, resulting in billions in losses to CLO investors .

The reason is that, for lack of a better word, CLOs - like CDOs over a decade ago - are the financial equivalent of alchemy: these structured credit products take a portfolio of mostly junk loans - which are used to fund much of corporate America - and repackage them in such a way that the resulting product looks and feels much higher in credit quality, even though it consists of the exact same junky underlying securities, just presented in a different way.

The problem with such financial alchemy, of course, is that it does not actually work and instead it relies on a set of underlying conditions that will prevent any participant in the CLO market from yelling "the emperor is naked." The most important such conditions are that risk assets continue to rally, that cash flows remain more or less in line with expectations, and that there are no major shocks to the system preventing wild rating swings forcing a repricing of the collateral stack.

Alas, March unleashed a "perfect storm" for CLOs where these three conditions hit at the exact same time, with risk assets plunging, cash flows for countless levered companies suddenly cut off, and rating agencies warning that hundreds of CLOs would face widespread downgrades. And suddenly this alchemy which facilitated the issuance of hundreds of billions in leveraged loans, resulted in billions in arrangement fees, and made dozens of hedge funds managers filthy rich, is nothing more than lipstick on a pig.

But before we get too far ahead of ourselves, let's answer the most important question: how does the CLO alchemy work in practice?

Take the example of the 2017 Long Point Park CLO. As part of the CLO process, the asset manager bought 361 loans worth $610 million, of which over 96% were rated junk. Having thus compiled a pool of almost entirely junk-rated loans, the manager then divided the scheduled payments from the CLO into tranches offering declining safety and increasing rates of return - starting at the top with AAA, then dropping to AA and so on, all that way to BBB, BB and B, before concluding with the riskiest, equity tranche, at the bottom. In such a way, 361 current-pay junk-rated loans were used to create a synthetic cap table, with the least risky on top and most risky at the bottom.

And here is the alchemy itself: since everything above the BB bond is by definition investment grade, this meant that a portfolio of mostly junk debt, thanks to the "magic" of CLO transformation which is also the process where investors collectively agree that the naked emperor is, in fact, dressed, ended up rated investment grade. In fact, as shown in the chart below, the original pool of a 96.4% junk-rated loans, was transformed into 86.6% investment grade synthetic bonds, and just 3.7% of the resulting "bonds" were rated speculative grade, or the same rating as the original assets!

Just like that, the Wall Street structured credit machine has converted a portfolio of 96.4% junk-rated loans into bonds that are just 3.7% junk rated, with 87% rated investment grade through the magic of "diversification", even though all those synthetic "investment grade" bonds have as collateral junk assets which are all effectively worthless during a systemic crisis.

And here is where the perfect coronavirus storm came into play.

Thanks to the law of large numbers and simple statistics, when aggregated across a large enough number of loans, defaults become a perfectly predictable and mundane event where one can easily extrapolate both cumulative losses and severity given a set of economic conditions. That's precisely why investors then end up buying any given CLO tranche: given an investor's risk tolerance and assumptions about marginal changes in the global economy, a risk-tolerant investor such as a hedge fund, who believes an economic slowdown is nowhere near, can buy the lowly-rated B note and earn a respectable yield. Other, more risk-averse investors - such as Japanese pensioners or UK insurers - end up buying the AAA or AA rated tranches, as these effectively guarantee no impairments, absent some unprecedented shock.

However, for all that to work, the core assumption is no outlier events, no unexpected turmoil, no sudden stop in the global economy, and certainly no economic depression where over 20 million people suddenly lose their jobs. The coronavirus crisis was precisely that, and suddenly virtually every loan that comprised the original portfolio of underlying CLO "assets" is in danger of default - after all these are nothing more than junk-rated loans issued by heavily levered companies whose cashflows are very risky and which are critically reliant on the lack of major outlier events. Which also means that all the bonds that were issued by the CLO, from the "safest" AAA tranche to the riskiest Bs and the equity tranche, can very well be worthless in a cataclysmic stress event such as a global economic shutdown.

Now, since none of what happened in March was supposed to happen - or was even conceivable by the CLO arrangers or investors - let's go back again to how a CLO is supposed to work in an ideal environment.

Traditionally, most CLOs limit the worst-rated loans to a maximum of 7.5% of the portfolio, the so-called CCC bucket. The limit is designed to protect investors from managers who may otherwise be tempted to take outsized bets to juice returns by loading the portfolio with higher-yielding, lower-rated loans (think Paulson's double-dealing with Goldman on various pre-financial crisis synthetic CDOs). Any CCC loans over the limit will be suddenly subject to mark-to-market rules, which means they’ll be counted at the current trading value rather than at par, reducing the value of the entire portfolio. That puts the CLO at risk of failing a critical test that measures asset-coverage, also known as the over-collateralization, or OC test. Failing that test cuts off cash-flow streams to certain investors - a mechanism designed to protect those who purchase less-risky segments of the CLO bonds.

But while CLOs tripping B, BB and even BBB overcollateralization tests is a frequent event during economic recessions, what happened in late April was unprecedented: a CLO just failed its AAA overcollateralization test for the first time. The CLO deal in question is JFINC152, where downgrades had sent the reported CCC percentage to 19%, up 9%, and the result is that every single test cushion is now showing impaired results, from BB (-4.7%) all the way to AA (-0.6%).

Which brings us to that other key variable: ratings.

As Bloomberg reported last month, Ratings companies were roundly criticized during the last financial crisis in 2008 for acting too slow in sounding the alarm over deteriorating credit. To avoid the same criticism, this time they are being far more proactive and have embarked on an unprecedented downgrade spree. Through the middle of last month, S&P and Moody’s had already cut ratings on some 20% of the loans that are housed in CLOs. Many more are coming. The loan downgrades have come so fast, one after another, that Stephen Ketchum of Sound Point Capital Management likened it to a spill "at the Daytona 500, where the cars are crashing into each other."

The barrage of loan downgrades will also prompt ratings agencies to downgrade the securities sold by the CLOs themselves, which are separate from the ratings on the underlying loans. On April 17, Moody’s surprised the market by putting $22 billion of US CLO bonds - nearly a fifth of all such bonds it grades - on a watchlist for a downgrade, saying that the expected losses on CLOs have increased materially. Some 40% of those securities had investment-grade ratings. Now keep in mind that among the buyers of CLOs are "rating-constrained" investors, such as pension funds, banks and insurance companies. If CLO bonds are downgraded - especially if they are cut from investment-grade to a junk tier - investors usually are forced to sell or risk higher capital charges.

The more the downgrades, the greater the losses to CLO investors. As of a month ago, the vast majority of CLOs had already blown past the CCC cap, up from just 8% that were breaching buckets earlier this year. In addition, some 20% of CLOs that submitted their monthly reports indicated that they are failing tests and will be turning off some cash flow to equity investors. And, as we first reported last month, things are so bad that a few were even failing tests that measure asset coverage of the highest rated AAA/AA tranches, according to an April 20 report from the bank.

Keep in mind that all that it taking place before the "biblical" wave of bankruptcies has even hit. Just wait a few months.

So what are portfolio managers to do? Strictly speaking they have two options: dump lower-rated loans at fire-sale prices, or cut cash payments to some of their investors. In the first case, selling loans can cause a CLO to crystallize losses - a likely event because lower-rated loan prices are lagging. The other path of turning the cash spigot off and shifting to payment-in-kind, or PIK, where interest is paid with more debt, can ravage equity returns, depress lower-rated CLO bonds and cut off a substantial portion of the CLO manager’s fees.

A look at CLO prices tracked by Palmer Square shows that there certainly has been a lot of dumping: and while higher rated tranche prices have enjoyed a modest rebound in recent weeks, the BB and BBB remain stuck deep underwater, because one of the few assets the Fed has not (yet) bailed out are CLOs.

And just like stocks, the underlying assumption for the rebound shown above is that the reopening from the coronavirus pandemic will be swift and V-shaped. We disagree, especially since the cascade of downgrades signaled that a wave of defaults is coming. As Bloomberg notes, analysts have hiked their expectations for how many of the underlying loans will sour, and lowered their forecasts for how much might be recovered from each bad loan, although as with equities, their forecasts remain anchored to a cognitive bias of normalcy, when the global economy is anything but. This means that US high-yield default rates could run to double-digits, perhaps surpassing heights of about 15% in the last financial crisis, while loan recovery rates could be slashed to far below the generic assumption of 60 cents on the dollar, and far lower than past norms. But, as Bloomberg correctly points out, history provides only a limited guide: The market for leveraged loans has exploded in recent years, with U.S. total issuance ballooning to $1.2 trillion as the market became the go-to place for private equity firms to finance debt-fueled buyouts.

And it all worked splendidly as long as nobody questioned the "alchemy" behind the biggest magic trick Wall Street pulled in the past decade. Alas, alchemy does not exist, and just like all those buying "gold" from carnival charlatans eventually realized they were holding on to lead, so all those who naively believed they had purchased investment grade securities are about to learn the hard way that what they really owned was, aptly-named, jun

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To: Worswick who wrote (2738)5/12/2020 10:24:43 AM
From: ggersh
   of 2789
2020 a rerun of 2008 which was a rerun of 2000 which all
began in 1987 when raygun created the PPT

As a TV series would we call it As Amerika Burns

I imagine soon people will be on the streets

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