Saturday, September 20, 2008

Derivatives + Off Balance Sheet Items = Overnight Failure?

I have to wonder what else contributed to the fast fall of Bear Sterns, Fannie Mae, Freddie Mac, Lehman Brothers, and A.I.G. Yes, having the resale market for mortgage backed securities dry up overnight could be fatal. But is something else contributing to their fall?

America's financial innovation produced a bowl of alphabet soup like products that cranked up the risk/reward angle. They make money hand over fist on the way up, but turn into a flesh blender when markets turn bad. Did these products cause the widespread, sudden failures?

I poured through several of Lehman's annual reports and something jumped out, their off balance sheet trading of derivative financial instruments. In 2004 they comprised $470 billion of obligations. By 2007 they'd grown to nearly $740 billion, more than all of Lehman's assets. What if derivatives went in the tank, if the market dried up? What if they became as hated as subprime mortgage backed securities? Could they wipe out Lehman's book value of $40 per share overnight? Lending credence to my concern, the SEC is now probing derivatives trading, including credit default swaps.

Not long ago, a business declared bankruptcy overnight. It happened recently to The Carlyle Group's energy affiliate, SemGroup, which lost billions trading energy contracts. Such trading was not listed as a major focus of the firm in their SEC documents. They bet the wrong way, costing shareholders the firm. Debt holders now manage SemGroup's reorganization.

What role has off balance sheet trading in speculative financial instruments played in the current broad meltdown? If I get to pick up the pieces via a $1.5 trillion increase in the national debt ceiling, I'd like some answers. The Bush administration has a long and storied record of not coming through.