In this issue:

Fed Must Prepare World for Ugly News: Rates Will Rise

Bundesbank: Derivatives Risks Threaten Financial System

When the Markets Announce Financial Catastrophes....

Financial Warfare Opened Against Brazil


From Volume 3, Issue Number 17 of Electronic Intelligence Weekly, Published Apr. 27, 2004

World Economic News

Fed Must Prepare World for Ugly News: Rates Will Rise

A few days before the semi-annual gathering of the International Monetary Fund (IMF), World Bank, and the G-7 Finance Ministers and Central Bank governors, key quotes from the new "World Economic Outlook" have been leaked to the media. The IMF will release the report on April 21, which will be a topic of the discussions over the April 24-25 weekend. According to London's Financial Times April 19, which says it received a draft of the main chapter through its Spanish affiliate Expansion, the IMF warns that the Fed must prepare the world economy for higher interest rates to "avoid financial market disruption both domestically and abroad."

Formulated in the what the FT terms the "cautious language of international economic diplomacy," the IMF warns that "the ground should continue to be prepared for future monetary tightening...." Rising U.S. interest rates, the IMF says, besides the obvious consequences for U.S. bond and mortgage markets, could trigger further severe difficulties in emerging markets. Another risk to the world economy is the large U.S. current account deficit. Hopefully this could be neatly resolved. But, "A more disorderly adjustment—including abrupt movements in exchange rates—could not be ruled out. This would have significantly more serious consequences, with potential spillovers into other financial markets, including through higher U.S. interest rates."

While the IMF is very worried over the ultimate result of the Fed's liquidity generation, once rates start to rise again, it actually is demanding euro-zone open the monetary floodgates even wider. The IMF says: "Further easing would be appropriate if as a result of these or other factors inflation looked likely to fall below the desirable level." Presently the European Central Bank prime rate has stayed at 2.0%, twice the Fed's base rate. However, Germany's prime rate is reportedly at its lowest prime rate since 1876.

Bundesbank: Derivatives Risks Threaten Financial System

The high concentration of risks in credit derivatives "could threaten financial system stability," the Bundesbank warned in a 20-page feature headlined "Instruments for credit risk transfer: its use by German banks and aspects of financial stability," released April 20. The bank's Monthly Report is written in typical central banker's language. While the Bundesbank starts off by portraying credit derivatives as useful financial innovations that increase the "flexibility" of the system, it then adds a lot of "buts."

At the end of the third quarter of 2003, the credit derivatives contracts of German banks amounted to 566 billion euros. Usually, one would expect that in most of these contracts, the banks were giving away their credit risks (the "buyer" of the credit derivative) while the counterparty were an insurance firm or a hedge fund taking this risk (the "seller" of the credit derivative). However, this is not the case. First, it's interesting that German banks are entering the credit derivative markets in order to take over additional credit risks (263 billion euros) nearly as much as to transfer existing credit risks (303 billion euros). Furthermore, the Bundesbank survey reveals that 83% of credit derivatives contracts with German bank participation are "inter-banking" contracts, that is, both parties are banks. Most often (in 67% of all cases) the counterparty is a foreign bank.

Credit derivatives in general reduce the powers of supervision agencies, because credit risks are being traded with counterparties abroad, including hedge funds or financial institutions based in offshore centers, says the Bundesbank. However, the most worrying aspect concerning credit derivatives is the concentration of credit derivatives among a few banks. The Bundesbank notes that this is a problem effecting all types of derivatives. Its survey found that the top four German banks account for 78% of all credit derivatives with German bank participation. What happens if a single large player in the credit derivatives markets—for whatever reason—suddenly decides to drastically cut down its derivatives exposure? The "liquidity illusion" in this market segment would suddenly disappear. Other market participants could then suffer losses, forcing them to liquidate asset holdings. "Due to this selling pressure, the disturbance could spill over to other financial markets and other market actors." All of this increases the "systemic damage potential" of a single negative market event. The Bundesbank therefore calls on the banks to establish appropriate "risk management" procedures, including covering the risks with enough core capital. Otherwise, concludes the Bundesbank feature, these risks "could threaten the financial system stability."

When the Markets Announce Financial Catastrophes....

Without mentioning explicitly the current threat of a financial blow-out, Muriel Motte obviously has this in mind when writing in Le Figaro Economy April 20 about how "investors go to the more sophisticated financial products, in the search for advanced indicators of coming financial catastrophes." Motte writes that credit derivatives markets, called "default swaps" in France or "CDS" in English, are better indicators of possible crashes than the bond markets themselves. When a bank lends money to a company at high risk and wishes to cover that risk, it buys a CDS from an insurance company or a hedge fund, a product which guarantees full reimbursement in the case of catastrophe.

In the recent period, due to the increasing indebtedness of companies, this market has literally "exploded," says Motte, signalling that it represents some $3.5 billion today (and is expected to go up to $10 billion by 2007). It is this "highly liquid" market which signals the great bankruptcies ahead of time, as was the case with Parmalat and Enron. The article is accompanied by a graphic which shows clearly a scramble for CDSs in the weeks prior to the failure of those large companies. Motte underlines the fact that at this point 350 to 400 companies in Europe already have default swaps attached to their debt.

Financial Warfare Opened Against Brazil

J.P. Morgan Chase set off financial turmoil on April 15, when it lowered its rating on Brazilian bonds, and sold some of its own Brazilian holdings. Morgan Chase, the world's leading trader in Brazilian bonds, just so happens to be the company which determines country-risk, the premium which many Third World and former Soviet bloc countries have to pay over U.S. Treasury bills to sell their bonds. Bank of America quickly followed with its recommendation that investors "substantially" sell off Brazilian paper, as did Merrill Lynch, Citigroup, Deutsche Bank, and others. When U.S. interest rates rise, they argue, Brazil's ability to service its debt becomes more doubtful.

Brazil's country-risk promptly rose by 9.3% on April 15, to hit 6.11%, and the value of its bonds and currency began falling. The banks' move served as a warning to the government of the kind of financial warfare it will face, should it give in to the enormous political and social pressure exploding in the country against the Lula government's capitulation to International Monetary Fund austerity.

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