Will BP Trigger a 'Black Swan' Event?

in the world of structured finance?

Citing Moody's analysis, Zero Hedge reports that BP's bankruptcy would impair more than just the BP's debt holders and equity holders. The loss in CSOs (collateralized synthetic obligations, often using credit default swaps, or CDS) that reference BP and the companies that are involved in the Gulf oil spill - i.e. Transocean, Halliburton, Anadarko, and Cameron could be billions of dollars. If you include other oil and oil service companies that would be negatively affected by the spill, the amount could be hundreds of billions, as it would also involve companies totally unrelated to BP or oil industry but unfortunate enough to have their CDS packaged with BP's.

BP's Bankruptcy Would Impair 117 (18% Of Total) Collateralized Synthetic Obligations, Lead To Pervasive Losses (Tyler Durden, 6/21/2010 Zero Hedge)

"Even as increasingly desperate falling knife catchers try to convince someone, anyone to buy up some or all of their shares of BP stock, which is certainly on its way to a guaranteed doubling, tripling or more, the real investing community is ever more carefully looking at the worst case, and its implications. Said implications would be vast, and in addition to wiping out billions in capital from BPs direct counterparties which are already limiting their BP exposure, a topic we touched upon briefly previously, would also impair indirect holders of pre-packaged securitized BP exposure. Today Moody's provides an analysis of which CSOs (just like CDOs but packed purely with synthetic products - think Goldman's Abacus) would be impaired should BP go bankrupt. The rating agency does not stop there, and also analyzes what a bankruptcy of BP peers Halliburton, Anadarko Petroleum, Transocean Inc., and Cameron International would look like, and who would be wiped out. Below are the results, which upon further analysis will likely indicate total loss potential well beyond BP's total outstanding debt exposure.

"As the recent civil case involving Goldman and the Abacus (and soon potentially others) CDO showed, collateralized products have a special place in the heart of the regulators, due to their avalanche quality of blowing up seemingly completely unrelated entities, which share merely the stupidity of having invested in the same entity. BP, as a company with over $20 billion in debt outstanding, has over the years, seen many of its CDS packaged and repackaged in the form of many and increasingly more complex CSOs. Last week's blow out in BP spreads, in which the 1 Year CDS surged beyond 1,000 bps, has got many people concerned: the least of which are counterparties that are on the other side of the short risk trade. Others include investors in just such CSOs, and other companies whose CDS comprises various tranches in these synthetic obligations, as forced liquidations in any given CSO would result in the blow out spreads in even perfectly solvent companies who just have the displeasure of being packaged in one and the same CSO." [Emphasis is mine. The article continues.]

The whole point of structured finance is to transfer risk by securitization, tranching, credit enhancement and rating. But as we have seen in the past two years, instead of reducing the risk these CDOs seem to do the opposite and amplify the risk in times of acute financial stress. Zero Hedge article concludes:

"Should BP go down it will, on a diluted basis, wipe out many more pro rata billions in value once protection sellers scramble to cover margin and collateral calls. Add the other drilling usual suspects, and the losses could amount well into the hundreds of billions." [Emphasis is mine.]

I would love to know who wrote those protections. And the names of the unfortunate companies whose CDSs were packaged with those of BP.

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Chinese Firm Sticks It to Morgan Stanley

Taste of things to come, probably.

China Haisheng Juice Holdings, a Chinese company that makes and exports apple juice concentrate, settled out of court with Morgan Stanley over the currency derivatives contracts.

Instead of $27 million that Morgan Stanley had insisted the company pay, China Haisheng Juice holdings got away with paying only $7 million, 26 cents on a dollar.

Morgan Stanley settles derivatives lawsuit with Chinese company
(1/7/2010 Financial Times)

"Morgan Stanley has ended a confrontation with a Chinese company over disputed hedging contracts in an out-of-court settlement that may be a model for ending similar disputes involving mainland enterprises.

"The Morgan Stanley dispute with China Haisheng Juice Holdings was the most public of many between foreign investment banks and dozens of mainland Chinese companies over lossmaking derivatives deals

"Under the settlement, Haisheng will pay Morgan Stanley $7m, far less than the $26m the investment bank had been fighting for in London's High Court after the Chinese company ceased payments on the hedges.

"Haisheng will dismiss its legal proceedings in Xian, Shaanxi province, where it was counter-suing Morgan Stanley for allegedly mis-selling the contracts.

"A legal battle in China would have subjected Morgan Stanley to financial and political risks, lawyers said, making the settlement the most attractive option.

"But the agreement could encourage other Chinese companies to take legal action against foreign banks at home as a tactic to escape lossmaking contracts, lawyers warned."

So they give up on pursuing the full payment on the derivatives that they sold, if the counterparty is Chinese. A stark contrast to what they did to AIG, with the help from then-Federal Reserve New York president.

By the way, a sublime irony in this Morgan Stanley case is the fact that this juice company is 20% owned by Goldman Sachs, as this article mentions. Vampire Squid is everywhere, and on the winning side. Well, almost always.

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Regulators Want to Regulate Derivatives.. Good Luck with That

If career bankers don't understand complex financial products of their own creation (see my previous post), do you think politicians and bureaucrats understand?

Regulators seek tighter oversight of derivatives
(10/7/09 AP via Yahoo Finance)

"WASHINGTON (AP) -- As two federal regulators asked a House panel to tighten proposed legislation imposing new oversight on derivatives, Republican lawmakers contended the measure already could eliminate jobs and stifle companies' ability to manage risks.

"A potent new coalition of about 170 companies that use derivatives -- including Boeing Co., Caterpillar Inc., Ford Motor Co., General Electric Co. and Shell Oil Co. -- is lobbying Congress to make the case that legislative proposals to regulate the complex financial instruments could severely increase costs for corporate America.

""The end-user community has been constantly knocking on my door," Rep. Frank Lucas, an Oklahoma Republican, said Wednesday at a Financial Services Committee hearing.

"Companies of all kinds use derivatives to hedge against risks -- airlines ensuring against spikes in fuel prices, for example. At the same time, the complex products have become a growing vehicle for financial speculation and ballooned into a $600 trillion global trade. Regulators say they pose a threat to the stability of the financial system."

(You can read the rest of the article by clicking on the link above.)

Opponents contend that the proposed regulation would raise the cost of capital by requiring large collateral from companies that use the derivatives for their operations.

I see a problem from a slightly different angle.

What would the government regulators do when the counterparties renege on the derivative contracts, and those counterparties happen to be foreign entities? Or worse, foreign government entities? How do they enforce the regulation across the border? Do they have jurisdiction? (Short answer is No.)

Chinese government-sponsored corporations come to mind. They are threatening to default on commodity derivatives now, and they already defaulted on the forex derivatives last year (see this post from Tavakoli Structured Finance, Inc., link was from Jesse's Cafe Americain).

And their counterparties? I read somewhere long time ago that 10 biggest players in the world in derivatives trading get 90% of the business. It's not hard to guess who, and many of them are U.S. banks.

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Which Derivatives Will China Renege?

News hit the wire late August-early September that China may renege on their commodity derivative contracts with unnamed six foreign banks.

Derivative deals hit a rough patch (9/1/09, People's Daily Online)

"Chinese State-owned enterprises (SOEs) may unilaterally terminate derivative contracts with six foreign banks that provide over-the-counter commodity hedging services, Chinese business magazine Caijing reported, citing unnamed sources.

"The report said that the State-owned Assets Supervision and Administration Commission (SASAC), China's SOE watchdog, has informed the financial institutions in written letters that SOEs reserved the right to default on those derivative contracts."

The derivatives in question are reported in the U.S. to be oil hedges. They certainly could include oil derivatives, but consider this peculiar phenomenon: it was gold, silver, and gold/silver miners that jumped big on the news.

Further checking this article, I found this paragraph [emphasis is mine]:

"The Caijing report, quoting an unidentified SASAC official, said that almost every SOE involved in foreign exchange or trade had some exposure to derivatives such as crude oil, non-ferrous metals, agricultural commodities, iron ore and coal, although only 31 SOEs were licensed to do so."

What are "non-ferrous metals"? According to GlobalSpec, "Nonferrous metals and nonferrous alloys are not based on iron and include alloys of aluminum, copper, titanium, zinc, nickel, cobalt, tungsten, precious metals, and refractory metals."

Long positions in oil, if they entered near high must be painful (as U.S. university endowments should know very well); also painful would be short positions in gold and silver, which they may have entered into to hedge their domestic operation (China is a large gold producer).

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