Streetwise Professor

October 2, 2010

Collateral: No Silver Bullet

Filed under: Clearing,Commodities,Derivatives,Economics,Exchanges,Financial crisis,Politics — The Professor @ 3:44 pm

The Hunt brothers are the poster children for the old joke: “Want to make a small fortune trading commodities?  Start with a large one!”  [Ba Dum Ching!]

Their not-so-excellent silver adventure is also an interesting object lesson in other ways.  In particular, it shows that clearing, initial margin, rigorous daily mark-to-market variation margin, and exchange trading are do not immunize the broader financial markets from contagion originating in the derivatives markets.

It is no doubt true that initial and variation margin reduce the credit exposure in a specific derivatives trade.  But that doesn’t mean that requiring collateralization of derivatives trades in a way that dramatically reduces credit exposure in a particular trade reduces the amount of leverage in the system; or reduces the likelihood of default against that borrowed money as the result of an adverse price move in the derivatives market.

This is because the creditworthy will get credit, until they aren’t.  If you deny them one channel to obtain credit (e.g., by charging hefty margins on futures trades) they can get credit through other channels.  They can use that credit to support their speculations in derivatives markets.  And if those speculations go the wrong way, it can cause the formerly creditworthy to default.  If they’ve borrowed enough, the whole system can have trouble.

That’s exactly what happened in the Hunt case.  The Hunts borrowed, from various sources, approximately $1.3 billion to support their silver market activities. That’s the equivalent of about $3.5 billion today.  They used the borrowings to pay margins and to buy physical silver.  When the price of silver fell, they couldn’t pay back their loans.  This almost led to the failure of several major brokers and banks, and could have sparked a full-scale banking crisis.  In a process not too different from that involved with the rescue of LTCM in 1998, banks restructured the Hunts debt in order to avoid a crisis: the Fed’s (and Paul Volcker’s) role in this was and is very murky, but (a) it was decidedly contrary to stated Fed policy at the time, (b) Volcker could have killed it if he had wanted, but (c) it happened.  So draw your own conclusions.

Here are the details.  After skyrocketing in late-1979, the price of silver started to drift down in 1980.  The Hunts needed cash to meet margin calls, and they borrowed money–about $233 million–from their main broker, Bache.  The loan was collateralized by silver.  Bache, in turn, rehypothecated the capital and used it to back borrowing of the money from First National Bank of Chicago.  In addition, the Hunts borrowed large sums from Swiss Bank, as did their pilot fish in this endeavor, a group of Saudi investors who were trading through the firm IMIC.  In addition, IMIC borrowed money from Merrill Lynch and commodity broker ACLI.

Most of these borrowings were used to meet margin calls.  Most of these borrowings were collateralized with physical silver.

Prices continued their downward drift, and on 17 March, 1980 the Hunts missed a margin call.  Bache covered it.  IMIC also missed margin calls on 3/25.  Broker Conti covered it.

The price decline the accelerated, and threatened to turn into a rout, when the Hunts announced an ad hoc, not to say harebrained, scheme to sell silver bonds.  This signaled to anybody paying attention that the heretofore supremely confident silver bulls were having serious cash flow issues.  The prospect of their silver hoard (and that of their IMIC shadow) being dumped on the market put prices under serious pressure.

On the 26th, the Hunts told Bache they could not meet any additional margin calls.  Bache panicked, and tried to get the CFTC and COMEX to close the silver market, and force settlement of all outstanding contracts at a price that would allow the Hunts to pay them back.  COMEX and CFTC refused.

The market therefore opened on the 27th–“Silver Thursday.”  Bache liquidated Hunt positions, and sold silver held as collateral.  It made the sales in London through a UK subsidiary, incurring losses–but Bache NY promised to cover the losses.

There were serious concerns that day that Bache would go under.  The CFTC deemed other brokers to be vulnerable, notably ACLI, Conti, Merrill, and Paine Webber .  A default by any one of these would have put the COMEX clearinghouse in jeopardy: a default by more than one, almost certainly would have.  The Fed’s (now) venerable Gerald Corrigan, openly worried about the viability of the COMEX clearinghouse.  Given the realized and potential losses, a COMEX clearing failure was a real possibility.  Again: clearing is not a panacea.

To raise cash to meet its obligations to the clearinghouse, Bache dumped stocks as well as silver.  They were not alone.  Stocks declined rapidly, the Dow losing about 5 percent, before recovering to close almost unchanged.  (Another interesting sidelight of this episode: a “Flash Crash” years before anybody even dreamed of HFT.*)

But Bache was able to scrape together enough money to meet its obligations to the clearinghouse and pay off its loans.  The owners of ACLI and Conti injected capital. Things seemed to be under control.  Disaster seemed to have been averted.

Not so fast.  When prices were sky high, silver giant Engelhard was having a difficult time meeting margin calls on its short COMEX silver futures positions.  So it had entered into exchange-for-physical (EFP) deals with the Hunts, whereby the Hunts agreed to take the Engelhard short positions (which were offset against some Hunt longs), and agreed to buy physical silver from Engelhard for delivery at the end of March, 1980.  Again–more credit, this time, extended by Engelhard to the Hunts.

When the delivery date came, based on the sales price in the EFP contracts and the prevailing price of silver, the Hunts were underwater by $335 million.  Engelhard insisted on cash.  The Hunts said sorry, ain’t got no cash.

Engelhard could have forced the Hunts into default and bankruptcy.  If that had happened, the entire Hunt debt pyramid, all $1 billion plus, would have been in default.  Several banks would have been at risk of failure–First Chicago, the nation’s 9th largest bank, most notable among them.

But Engelhard blinked–or did the country a favor, depending on how you look at it.  It accepted some Hunt oil properties in the Beaufort Sea instead of cash.

Another bullet dodged.  But the banks still realized that the Hunts were in hock to them for huge sums, and a good chunk of the brother’s wealth was still in silver that was worth a fraction of what they had paid for it.  There was still a serious risk of default, and the Hunts had a lot of bargaining leverage.  The prospect of a protracted war in bankruptcy court was hardly appetizing to the banks.

So they bit the bullet (sorry–free association at work), and renegotiated the loans with the Hunts.  The loans to the brothers were paid off by a new loan to the Hunt family oil firm, Placid Oil.  Finally, the problem was taken care of.

The role of the Fed and Chairman Volcker in this loan is shrouded in mystery. Congress pressed Volcker for answers, and he, in classical central banker fashion, obfuscated and stiffed them.  But it should be noted that the loan was starkly at odds with the Fed’s new policy of restricting credit, most especially credit for commodity speculation.  Volcker had insisted that the loan include the condition that the Hunts cease speculating in all commodities, not just silver.  Moreover, given the Fed policy and its power, if Volcker had wanted to stop the loan, there is no doubt he could have.  Thus, there is evidence of both active and tacit Fed approval of the ultimate solution.

This arrangement foreshadows the solution, 18 years later, to the LTCM problem.  Then, as in 1980, the Fed shepherded a group of private banks to finance the resolution of the victim of a derivatives blowup.

To sum up.  Here we have a market that was (a) exchange traded, (b) cleared, (c) subject to initial margins, and (d) subject to rigorous daily variation margins.  All of the things that our latter day financial reformers assert will purge derivatives-related financial contagion from the system.  Yet a derivatives-related financial contagion occurred nonetheless.

Why is that?  The reasons are pretty clear.  The real source of potential derivatives related contagion exists when (a) a large entity takes on a substantial price risk through the derivatives market (or the underlying market, e.g., silver, or both), and (b) that entity is highly leveraged.  The clearing, margining, etc., is intended to reduce the leverage extended to the entity via the derivatives transactions.  But even if it doesn’t get credit via the derivatives trade, a creditworthy entity can use its debt capacity to get credit elsewhere.  If it does so, and its speculative bet goes wrong, it may default.  If it borrow enough, the default may lead to a financial crisis.

The default may impact the clearinghouse.  Clearing members may be among the defaulter’s creditors.   The default may lead to missed margin payments.

But even if the clearinghouse survives, a crisis may occur nonetheless.  It’s the total amount leverage that matters most, far more than the form of that leverage.  If a given position is collateralized, thereby reducing the credit exposure inherent to it, but that collateral is effectively borrowed, the risk to the system isn’t any different than if the position isn’t collateralized but the entity doesn’t do any other borrowing.  All that really changes is who ends up carrying the can in the event of a default.

This is a Modigliani-Miller-like result.  It means that regulating the credit in one part of a position doesn’t really matter if the entity can obtain credit elsewhere.  If that entity has a given debt capacity, or target debt level, they’ll get the credit somewhere.  This means that you can’t really affect the systemic risk posed by big speculators by limiting their access to one channel of credit.

Which further means that requiring the clearing and collateralization of speculative positions will not substantially reduce the systemic risk posed by speculative trading.  Nor will exchange trading.  You can take risk on an exchange or off.  You can get credit through a derivatives trade, or elsewhere.  Either way, a big speculator can put together the same price risk + leverage position.  It is that risk+leverage exposure that matters, not how you get there.  Clearing and exchange trading mandates just affect the route, not the final destination.

The Hunt episode should thus serve as a cautionary tale.  Like the story of the Gold Panic of 1869, it shows that cleared, exchange traded markets pose systemic risks too.  Married with some rather straightforward economic logic, these episodes show that you should not expect that mandating how things are traded and how they are collateralized will materially affect systemic risks.  Those who assert the contrary are missing the forest for the trees, and instilling a false sense of security.

PS.  That shouldn’t cause you too much extra work, Allan:)

* Speaking of the Flash Crash, I’ve read the CFTC-SEC joint report. I will post on it tomorrow.  Teaser: the report leaves the most interesting and important questions unanswered.

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6 Comments »

  1. […] This post was mentioned on Twitter by John Avery and darachennis, Nick Wright. Nick Wright said: Streetwise Professor » Collateral: No Silver Bullet: … reduces credit exposure in a particular trade reduces the… http://bit.ly/aMbEN8 […]

    Pingback by Tweets that mention Streetwise Professor » Collateral: No Silver Bullet -- Topsy.com — October 2, 2010 @ 6:11 pm

  2. All that clearing, regulation and alleged oversight can’t prevent price manipulation in commodities if very wealthy insiders are determined to make it happen? Wow Professor, it sounds like you’re on your way to writing for Zero Hedge (currently Alex ranked in the top 1,300 sites in the U.S., not bad for a finance blog, and about 200,000 spots ahead of this site and 400,000 spots ahead of Phobie).

    Comment by Mr. X — October 3, 2010 @ 5:57 am

  3. @Mr. X. I think Zero Hedge is aptly named–it is high variance, so obviously not hedging. They have a tendency to verge towards the conspiratorial far more than I. Moreover, they have some obsessions, e.g., HFT, that I do not share. ZH finds the acorn every once in a while, but also miss the mark ridiculously quite often.

    If you are familiar with my academic research, and some things I’ve written on the blog, you will be aware that when it comes to manipulation, I have written extensively on how it is possible to deter (subtly different from prevent) price manipulation. It’s quite straightforward, actually, but the CFTC have made a complete and utter hash of it. Since they’ve demonstrated their abject incompetence in this area, I am of course quite sanguine about the effects of vastly expanding their powers.

    This post has nothing to do with manipulation per se. It is about how it is futile to try to regulate overall leverage by regulating just one way of levering up. It is sad that this rather straightforward, not to say obvious, point needs elucidation, and that the Sorcerer’s Apprentices/Mr. Magoos that write and enforce the laws are oblivious to it.

    And I’ve never been into the whole my-stats-are-bigger-than-your-stats thing. I am more interested in the quality of my readers, including sweethearts such as you.

    The ProfessorComment by The Professor — October 3, 2010 @ 9:23 am

  4. In the real world do you know Leo Linbeck III from the Belmont Club? Seems like your type of Houstonian.

    “They have a tendency to verge towards the conspiratorial far more than I.” We are living in conspiratorial times, Professor. Mere greed, shortsightedness and incompetence does not seem sufficient to explain many things, whether you’re talking about the underwear bomber or other stuff.

    As for my reference to Phobie, I do enjoy mentioning ‘her’ and Jamestown Foundation in the same sentence. It’s like garlic to vampires, they run away every time, as if they are terrified of those two words appearing in the same Google search. Well, live by the Google bomb, die by the Google bomb…

    As for Zero, I don’t think it’s a coincidence that the pseudonymous Tyler Durden hails from a former Communist Bloc state, Bulgaria. Nor that the scourge of Gubm’t Sachs, Matt Taibbi, used to write for the eXile in Moscow. A post-Soviet mentality would seem to lend itself to the notion that the ‘fix’ is always in from a conspiracy at or near the top.

    Zero reported this past week a tacit acknowledgment by Pimco that they’re getting insider info straight from the Fed conference committees three weeks before it gets to the market — just the latest in a string of stories showing that the dumb money is tired of getting led like calves to the slaughter.

    Comment by Mr. X — October 4, 2010 @ 5:46 am

  5. “A post-Soviet mentality would seem to lend itself to the notion that the ‘fix’ is always in from a conspiracy at or near the top.” a post-script too on this – I have heard one distinguished academic mention that a Deutsche Bank investment banker told him back in 1997 that an obscure but efficient German speaking aide in the St. Petersburg administration was going places soon. That man was Vladimir Putin, of course. So you can say what you like about conspiracy theories Professor, but some people experience what to outsiders appears to be a meteoric rise for a reason.

    Comment by Mr. X — October 4, 2010 @ 5:49 am

  6. FYI, I am an expert in a case against PIMCO, and I have no illusions about them, to be sure.

    The ProfessorComment by The Professor — October 4, 2010 @ 10:13 am

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