Take American International Group (NYSE:AIG): Regulations allow firms with the highest credit ratings to enter swaps and other exotic derivatives contracts without depositing collateral with their counterparties (those on the opposite side of the trade). When AIG was downgraded during the financial crisis in 2008, the firm was instantly required to post collateral to the potential tune of $85 billion — collateral it didn’t have. That meant the U.S. government — i.e. taxpayers — had to create a special secured credit facility of the same amount. Whether you view that as a backstop or a bailout is a matter of perspective.
That wasn’t enough. As AIG’s stock continued to weaken — and ratings were dropped further as the company’s financial strength deteriorated — the government had to create additional facilities against which AIG ultimately drew $90.3 billion against a total of $122.8 billion as of October 24, 2008.
Or, consider BofA. Downgrades impact BofA’s derivatives contracts will require the bank to put up more collateral in much the same way. At the same time, the downgrades could trigger termination provisions in the contracts that result in losses and ultimately further damage the already-struggling behemoth’s liquidity.
As for how that affects your wallet, it’s really pretty simple. Bank of America reported a third-quarter profit of $6.2 billion that was mostly accounting gains. A ratings cut could easily wipe that out, as well as any future gains in the months ahead — depending on the extent of the resulting damage it triggers.
And that’s part of the problem. Exactly how much damage lurks? There are more than $600 trillion in derivatives contracts that we know about. And there are potentially trillions more in collateral requirements that we don’t know about. These things are entirely unregulated — and that’s a huge part of the problem, even now.
Nobody knows what the impact will be, but we undoubtedly we’ll find out. My guess is that it will be in the hundreds of billions, and that money has to come from somewhere.
Perhaps that’s the real reason the Fed acted. Now that S&P has blasted the 15 biggest banks, the central bank is worried about the new updated ratings on the other 750 banks that S&P covers.
The Bottom Line: Don’t misinterpret this rally as anything other than what it is at face value — a complete farce and nothing more than a global form of QE3 — even though it’s not being called that.
A Look Ahead
Here are the things to watch:
The dollar is going to rally if the primary liquidity mechanism used remains dollar swaps. Gold will likely fall over the same time period. Oil will slip. And Treasuries will rise as traders come to terms with the real risks.
Then the real games will begin.
In the meantime:
- Don’t look a gift horse in the mouth
- Be nimble
- Harbor no illusions about what is happening
- Capture profits as they’re created
- Ratchet up your trailing stops if the rally gains legs
The Fed has merely saved the day, not the system (and I’m echoing the legendary Jim Rogers here, who originally made similar comments directed at the ECB’s actions during a CNBC interview in October).
The more drugs you inject into an addict, the more dependent he becomes on them. The Fed’s actions aren’t a solution on anything more than a short-term basis.