At Davos: Paul Singer To Warn Of Derivatives Catastrophe

Paul Singer, the outspoken hedge fund manager at Elliott Management, will not disappoint when he speaks in Davos, Switzerland at the World Economic Forum this January 22 at about 9:45AM EST. In fact Paul Singer's speech and later debate on the topic "Are Markets Safer Now?" is expected to shake the very foundation of the elite event, according to a letter to investors reviewed by ValueWalk. The topic was briefly mentioned in Singer’s Q1 2013 shareholder letter.

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Paul Singer

Based on a rough outline of Paul Singer's remarks reviewed by ValueWalk, the seventy year old activist investor will pull no punches as he will dismantle the notion of global financial stability and tear right into unregulated derivatives which he asserts are likely to be at the heart of the next economic crisis.

"We can only assume that the reason the global financial system is still… overleveraged, opaque, reliant upon the implicit and explicit support of governments for its very existence… is that fixing the problem would be too painful for powerful special interest groups," the rough draft says, setting up for the next warning and pointing to government bailouts and the political lobbying machine that ensures they remain intact.

In 2007 with fellow hedge fund manager Jim Chanos, Paul Singer warned the G7 finance ministers of impending global financial catastrophe and said the large banks were close to sinking the world economic system. Messrs Chanos and Paul Singer were ignored, which later caused a political uproar in the UK after the financial crisis they predicted occurred in 2008. Seven years after recognizing the last economic collapse, Paul Singer will be delivering a similar warning in Davos - and his message is similar that that of other derivatives experts.

After taking aim at political institutions caught in the self-serving spider web of lobbying, Paul Singer will note some progress has been made and then identify what he considers the primary issue facing the world economies today.

Paul Singer identifies key problems

"The major financial institutions those bailed out or implicitly supported in the last crisis have taken important steps to reduce their trading risks since the 2008 collapse. However, it is impossible to verify such progress from public financial statements or even to assess these institutions' true financial risks. Unfortunately, opacity and extreme leverage still reign supreme."

While transparency into the unknown depth and nature of the derivatives risk is critical, it is leverage usage to which Paul Singer has historically been most concerned and that he addresses most forcefully. The hedge fund executive is known to be loathsome of excessive leverage usage to juice returns and has generally shunned the practice in his professional life.

"There is a system, developed over decades, consisting of both industry practice and federal regulation, to ensure that secured 'margin' loans to the trading customers of financial institutions cannot become unsecured by the adverse movement of security prices. Customers must put up initial margin when entering a trade and have to post more if the equity in their account declines by a certain amount. A cushion is thus maintained, which protects the financial institutions and the system," the prepared remarks say.

Regulated derivatives usage follows strict guidelines for leverage and margin usage as well as requirements for complete transparency. Current estimates of the leverage usage in unregulated OTC derivatives that underlie the economies of the western world range from $600 to $700 trillion in notional value, far eclipsing the liquidating value of the banks that generally back these derivatives. The exact extent of the obligation is unknown due to the lack of transparency, but to provide perspective to the scope of leverage being used, the world economy is valued at $72 trillion. If these derivatives were to implode, as they did in 2008, it would literally wipe out the world economy several times over. Derivatives are like insurance contracts. The large banks have underwritten this insurance, most of which is tied to interest rates. If interest rates were to rise rapidly, which is possible given the government debt situation, it could trigger many of these derivatives and create a domino effect type economic crash. Paul Singer is not addressing an outlier event, but rather a situation that many inside the derivatives industry consider a probability.

"These systems, of how customers finance securities positions, and how banks are financed and operate, enabled the world's financial system to work without systemic collapse for more than 70 years after the Great Depression of the 1930s gave policymakers a solid to-do list of fixes which were necessary in order to avoid a repeat," Paul Singer's prepared remarks say. "Over the last 20 years or so, however, many of the world's financial institutions built astronomically massive books of derivatives, private equity, other illiquid assets and extensive proprietary trading positions which have dwarfed their traditional banking books and fee-for-services activities."

When Paul Singer says "last 20 years or so," he is likely referring to the point unregulated derivatives were first popularized by the large banks approximately two decades previous, a time when Jon Corzine was then running Goldman Sachs Group Inc ( GS) and was said to make frequent trips to Washington DC to flex new found power. It was 16 years ago when CFTC Chairwoman Brooksley Born warned about the dangers of unregulated, opaque derivatives and fought a brutal and lonely battle against the largest banks. Her goal was to do nothing more than have access to information, to study the depth of the risk exposure, much like Mr. Singer will advocate in his forthcoming speech. Ms. Born lost this principled battle. Time tested protections of regulated derivatives management that had served the country so well for more than 70 years, referenced in Mr. Singer's remarks, were dismantled when US President Bill Clinton signed into law the Commodity Modernization Act of 2000.

Paul Singer: World economy in the hands of the banks

These new "laws" did not establish any new guidance but only served the purpose of unwinding previous laws. A key result was allowing the largest banks to literally operate without restriction or supervision. The government placed the world economy in the hands of the banks, a blind trust of sorts, assuming banks would "do the right thing," that they were smarter than government. The derivatives were popularized and this apparent trust was released to the largest banks at a time when Mr. Corzine was running Goldman Sachs GS. Mr. Corzine was later ousted from Goldman Sachs by Chicagoan Hank Paulson, known as an "old school" Goldman Sachs banker who also warned the Bush White House in 2007 of a coming derivatives implosion. The groundwork laid in the mid and late 1990s to let the banks write derivative insurance contracts without restriction or oversight manifest itself in 2007 and 2008 as the unregulated derivatives collapsed the world economy, which has yet to properly recover. While this frames the issue, it is the next derivatives implosion of which Paul Singer is warning. He is not predicting the event with a crystal ball, but rather using the same mathematical logic that has worked so well for him generating one of the best long term hedge fund risk management profiles in the history of alternative investing.

"To the extent they represent trading between financial institutions, these derivative books in particular have been allowed by regulators, lenders and customers to be established with little or no initial margin, thereby removing the presumptive aura and reality of safety and soundness from the entire universe of major financial institutions. It is certainly debatable whether the system, and many of the 100 largest such institutions, were "unsound" before the 2008 collapse, but it is undoubtedly the case that these firms ceased being unquestionably more sound than their customers. In addition, when things started unraveling in 2007 and 2008, there was and still is insufficient useful, publicly available information to enable any customer to determine whether to stay with or run from institutions in which they have assets, trading relationships, claims or securities. This point is both irrefutable and critically important. It needs to be fixed. Contrary to what many policymakers would have us believe, no combination of regulation and edict anywhere in the world has yet to address the issue adequately.”

The next collapse, however, could be worse. To understand the magnitude of Paul Singer's concern at a fundamental level, imagine an insurance company with $20 million in assets insuring $60 billion in homeowners insurance with 70% concentration in the city of New Orleans just before hurricane Katrina. When Katrina hits, the insurance company would be required to pay $42 billion from $20 million in available assets. Obviously, it could not even come close to making the payments. The same is true with the $600 trillion unregulated derivatives insurance. Problem is, with the derivatives exposure so large and so concentrated, it could wipe out the world economy several times over. Even a government bailout could not cover the obligation without sending the world into an economic tailspin. It is from this perspective that Paul Singer is making yet another historic warning. Paul Singer's speech and subsequent debate, scheduled for January 22 from 3:45 p.m. to 5:00 p.m. CET, will be webcast live and available online for later viewing.

Mr. Singer will offer solutions in his forthcoming speech, the rough outline of which will be revealed in an article on Tuesday.

The post At Davos: Paul Singer To Warn Of Derivatives Catastrophe appeared first on ValueWalk.

-By Mark Melin

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