In fact, there isn’t that much of a difference between BP and Lehman Brothers – both have been among the major players in the unregulated $615 trillion OTC derivative market. If BP is forced to file for bankruptcy, it will probably have an even greater negative impact on the financial markets than the Lehman failure caused.
“Major BP risk lay in the $615T OTC Market that only the major international banks have any visibility to…. and they are not talking!”
Gordon T. Long
The potential contagion of the BP disaster may eventually show that Lehman Bros. and Bear Stearns were simply early warning signals of the devastation lurking and continuing to grow unchecked in the $615T OTC Derivatives market. What is yet unknowable is what the reality is of BP’s off-balance sheet obligations and leverage positions. How many Special Purpose Entities (SPEs) is it actually operating?
Well, this it what we know so far:
Remember, during the Enron debacle Andrew Fastow, the Enron CFO, asserted in testimony nearly 10 years ago that General Electric (GE) had 2500 such entities in existence.
BP has even more physical assets than both Enron and GE.
Furthermore, no one knows the true size of BP’s OTC derivative contracts such as Interest Rate Swaps and Currency Swaps.
Only the major international banks have visibility to what the collateral obligations associated with these instruments are, their potential credit event triggers and who the counter parties are.
They are obviously not talking, but as Gordon T. Long explains in a recent article, they are aggressively repositioning trillions of dollars in global currency, swaps, derivatives, options, debt and equity portfolios.
The Murky World Of Off-balance Products
“Once again – as we saw with Lehman Brothers and Bear Stearns – we have no visibility to the murky world of off balance sheet, off shore and unregulated OTC contracts, where BP’s financial risk is presently being determined,” Long writes.
“At a time when understanding a corporation’s risk position is critically important investors are in the dark. When markets are uncertain, bad things are certain to follow. The new financial regulations under the Dodd-Frank legislation does absolutely nothing to address this. This was the central issue in truly understanding and corralling TBTF risk. It has not been addressed and the markets will likely make the tax payer pay for this regulatory failure once again,” he adds.
Mr. Long is a former senior executive with IBM and Motorola, a principal in a high tech public start-up and founder of a private venture capital fund. He is presently involved in private equity placements internationally along with proprietary trading involving development and application of Chaos Theory and Mandelbrot Generator algorithms.
“Major BP risk lay in the $615T OTC Market that only the major international banks have any visibility to…. and they are not talking!” he writes in the article called “Sultans of Swaps”
Enron Times Ten
This is what Jim Sinclair at jasmineset.com says:
“People are seriously underestimating how much liquidity in the global financial world is depending on on a solvent BP. BP extends credit – through trading and finance. They extend the amounts, quality and duration of credit a bank could only dream of. You should this financial muscle behind a company with 100+ year of proven oil and gas reserves. Think about that in comparison to a bank with few tangible assets. Then think about what happens if BP goes under. This is no bank. With proven reserves and wells in the ground, equity in fields all over the planet, in terms of credit quality and credit provision – nothing can match an oil major. God only knows how many assets around the planet are dependent on credit and finance extended from BP. It is likely to dwarf any banking entity in multiples…. The price tag and resultant knock-on effects of a BP failure could easily be equal to that of a Lehman, if not more. It is surely, at the very least, Enron x10.”
As long as an energy giant can manage its cash flows throughout the volatility of price fluctuations, it becomes a money and credit generating machine.
It can borrow with AAA yield any where on the curve and lend to less credit worthy entities at attractive spreads.
These lending differentials help fuel the $430 trillion Interest Rate Swap OTC market.
BP has been able to spin off $20B of earnings for the last 5 years and $15B in cash last year.
All of this suddenly comes to an end if its credit rating is significantly impaired.
But what could possibly cause this to happen?
It would take a black swan event. An outlier. A fat tail.
Sound familiar? Heard this discussion before?
“The Gulf Oil Disaster may be the fat tail to end all fat tails and show the exposure behind the entire risk models of the vast majority of derivative algorithm models. To suggest that BP would need to take impairments north of $20 billion would have seemed out of the realm of possibilities less than 90 days ago. Now, if it is contained to only $20B, it would be considered a blessing. Fitch dropped BP’s credit rating an unprecedented 6 notches on June 15 from AA to BBB which followed June 3rd’s AA+ to AA cut. This is what happens when a fat tail occurs and it has only just begun,” Gordon Long writes.
BP’s Derivative World
Here’s what rating agencies, analysts, bloggers and journalist have managed to dig up, so far.
The CSO’s (Credit Synthetic Obligations):
A study by Moody’s outlines that a BP bankruptcy would impair 117 Collateralized Synthetic Obligations (CSOs) which would lead to pervasive losses by a broad range of holders.
The 117 effected is a startling 18% of the total CSOs outstanding, which is an indication of the scope and impact of BP financing globally.
For those that remembthe 2008 financial debacle, you will recall its epicenter was the collapse of Collateralized Debt Obligations (CDO) associated with mortgages and Credit Default Swaps (CDS) of financial companies impacted.
CSOs are even more leveraged and more toxic.
This is what Moody’s writes:
The CDS’s (Credit-default Swaps):
On June 25th BP’s Credit Default Swaps shot up 44 to 580 on the 5 years CDS. This meant it costs $580,000 per year to ensure $10 million in BP bonds over a 5 year contract period.
Anything approaching 300 is considered
serious risk. For counterparties willing to pay this amount means their dynamic hedging models are working overtime, and a near panic scramble is taking place.
On June 16 the blog Zero Hedge reported:
The Bond Inversion:
With Credit-default Swap consern we would expect this to be reflected in BP’s yield curve spread.
What is interesting is that the curve is inverted as BP’s CDS curve. Usually short term yields are less than longer yields because of inherent risk over a longer period of time.
This suggest that the market is pricing in a credit event.
A credit event would have a profound impact on OTC contracts, which we have no visibility to.
What we do know, however, is that BP has between $2 and $2,5 billion in one year commercial paper to rollover that is required for trading operations and working capital.
This is going to make it both more expensive and harder to secure, and will be a liquidity drain for BP.
The Liquidity Requirements:
To the commercial paper roll-over ($2-$2.5B in one year), ongoing new and rollover debt issuance, we need to add the $20B it has agreed with the White House to put in place, though we know of no detailed agreement actually being signed.
The Short Interests:
The Financial Times Alphaville via Data Explorers reported the short interest through June 4th.
By stripping out the spike related to the last dividend payment, the underlying level of stock outstanding on loan (SOOL) has barely budged since the Gulf spill.
So, short sellers can’t be blamed for the plunge in the share price; the selling must be coming from somewhere else, such as long-only funds.
Roumors circulated on June 10 that the Norwegian Government Pension Fund, who is the fourth largest shareholder in BP, was looking to offload 330 million shares.
Brokers said the total transatlantic volume of stock traded in BP on June 9 had a value of $8 billion.
To put that figure into some perspective, the total volume traded on the entire EuroStoxx index on the same day amounted to $15 billion.
Moreover, since the Deepwater Horizon rig exploded on April 21th, 70% of BP’s market cap has turned over, most of it the US.
Trading volumes in BP American Depository Reciepts (ADRs) are usually 19% lower than the ordinary shares in London.
Since the spill, that position has been reversed and the ADRs have traded 3,5 times the ordinaries, all of which suggests BP’s largest US investors base have been dumping stocks.
The Option Activity:
The Wall Street Pit wrote on June 19 that “Option volume on beleaguered oil company, BP Plc, is fast approaching 750,000 contracts, fueling a more than 79,7% upward shift in the stock’s overall reading of options implied volatility to a 5-year high of 120,96%. Options activity on the stock can easily be described as frenzied as volume continues to grow in both call and put options across multiple expires.”
The cost of capital is skyrocketing for BP which as fundamentally an energy financing corporation can be terminal.
Way Too Big To Fail
According to Gordon T. Long, the most likely scenario is that the US operations of BP will voluntarily attempt Chapter 11 bankruptcy proceedings.
“This the worst possible scenario for claimants. The problem here is that this triggers a credit event which has daunting repercussions to the highly leveraged global financial markets. Like AIG before, the government does not want to tamper with the ramifications and fall out of a CDS event. Lehman was one too many.”
“If a US voluntary bankruptcy is stopped by the US and there is a BP corporate bankruptcy, then there is a strong possibility that the British Government will be forced to step in and bailout BP. In the end, the tax payers will pay as the ongoing game of Regulatory Arbitrage is playing masterfully once again.”
“Deleveraging associated with BP may be the event that triggers the $5 trillion quantitative easing spike we have been warning about for some time now. It will be needed to complete the final process of manufacturing of a Minsky Melt-up to avoid the looming pension, entitlement and US state financial crisis.”
“The ability of the government to achieve this is anything but certain. However, we need to expect the unexpected and watch out for fat tails to trip over,” Mr. Long concludes.
Read also: Response To The BP Derivatives Story
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