By Pam Martens and Russ Martens: January 13, 2022 ~
On September 16, 2019, exactly one day before the Federal Reserve would embark on its first emergency repo loan operations since the financial crisis of 2008, $2.7 billion in credit default swaps (CDS) on a single name blew up. The dealers in those credit default swaps were the very same trading houses on Wall Street that sought, and received, tens of billions of dollars in repo loans from the Fed in an operation that grew to a cumulative $11.23 trillion before its conclusion on July 2, 2020. (In just the last quarter of 2019, the Fed pumped a cumulative $4.5 trillion in repo loans into Wall Street’s trading houses, according to the transaction data it released on December 30 of last year. That was before even one case of COVID-19 had been reported in the U.S.)
On September 16, 2019 the U.K. tour operator, Thomas Cook, filed for Chapter 15 bankruptcy protection in the U.S. District Court for the Southern District of New York – Wall Street’s stomping ground. We know that because the Credit Default Swaps Determinations Committee, that would render the ultimate decision on who got paid on the Credit Default Swaps and who didn’t, places that fact in the first paragraph of its final determination decision.
Eight days after that bankruptcy filing, on September 24, Reuters reported that the Determinations Committee had ruled that “some investors in Thomas Cook’s credit derivatives worth as much as $2.7 billion are eligible for a payout.” The same article revealed the source of that information was that the “weekly gross notional value for Thomas Cook’s CDS was $2.69 billion, according to the Depositary Trust & Clearing Corp (DTCC).”
What the DTCC was aware of in Credit Default Swaps on Thomas Cook is not the final word on the total amount that was at risk and eventually paid out. Wall Street firms continue to be able to write bespoke (custom) bilateral contracts on derivatives with only the two parties to the trade having knowledge of its terms.
The idea that the majority of derivatives are now being centrally-cleared is a complete falsehood that is well-documented quarterly when the Office of the Comptroller of the Currency releases its report on derivatives held at individual banks. The OCC’s report for the third quarter of 2019 shows that Goldman Sachs and Morgan Stanley were centrally-clearing zero percent of their credit derivatives, the bulk of which are credit default swaps. The maximum percentage other firms were centrally clearing in non-investment grade credit derivatives ranged from 2 percent to 38 percent. (See Graph 15 here.)
The most recent derivatives report from the OCC for the third quarter of 2021 reports the following on the central clearing of derivatives on page 13:
“In the third quarter of 2021 39.0 percent of banks’ derivative holdings were centrally cleared…From a market factor perspective, 50.5 percent of interest rate derivative contracts’ notional amounts outstanding were centrally cleared, while very little of the FX [Foreign Exchange] derivative market was centrally cleared. The bank-held credit derivative market remained largely uncleared, as 35.3 percent of credit derivative transactions were centrally cleared during the third quarter of 2021.”
In addition, Wall Street banks have moved some of their derivatives activity to their foreign units, beyond the radar of their U.S. regulators and the reporting scope of the OCC report.
Every major trading house and bank on Wall Street is aware of the black hole that exists around derivatives and this is why they ran for cover in 2008 and again on September 17, 2019. No one knew how much exposure any one derivatives counterparty had to Thomas Cook and whether it would set off a daisy chain set of defaults by the counterparties who couldn’t make good on paying out what was owed on their credit default swaps.
In Wall Street lingo, the big players in the repo market simply “backed away” from lending, spiking the overnight lending rate from 2 percent to 10 percent and forcing the hand of the Fed to step in and become repo lender of last resort to the trading houses on Wall Street – its so-called Primary Dealers.
When the final results of the Credit Default Swap auction of October 30, 2019 were revealed, to allow the close out of Credit Default Swap exposure to Thomas Cook, the same names that were getting the largest amounts of repo loans from the Fed’s emergency facility were on the list.
Beginning in May of 2019, hedge funds saw an easy prey in Thomas Cook. On May 22, Fitch downgraded the debt of Thomas Cook to CCC+ and placed it on negative credit watch. On July 17, Fitch downgraded the debt further into junk territory with a CC rating. On September 5, just 11 days before its bankruptcy filing, Fitch downgraded the Thomas Cook debt even further into junk territory with a single C rating.
Not only were hedge funds buying Credit Default Swaps on Thomas Cook, they were also assisting in its demise by shorting the stock. In the six months prior to its collapse, its share price had lost 85 percent. The Guardian newspaper in the U.K. reported that “Two hedge funds – London-based TT International and Whitebox Advisers, from Minneapolis – made up the bulk of the shorts, together holding around 7%, according to ShortTracker data.”
While Thomas Cook may have been the spark that ignited the inferno in the repo market, there were plenty of other problems contributing to a general distrust of each other among global trading houses.
According to a chart published by Bloomberg News on September 24, 2019, job cuts planned by global banks at that point tallied up to 58,200. Shortly thereafter, the Financial Times reported another 10,000 job cuts at HSBC.
On July 31, 2019 Fortune Magazine reported that “Trading revenue at the five biggest U.S. banks on Wall Street dropped 8% in the second quarter, following a 14% slide in the first three months of the year — setting up global banks for their worst first half in more than a decade.”
Two of the large borrowers under the Fed’s emergency repo program that were units of foreign banks were Nomura Securities International (part of a large Japanese bank holding company) and Deutsche Bank Securities (part of the giant German lender, Deutsche Bank). Deutsche Bank’s stock had been setting historic new lows throughout 2019 and in July of 2019 Deutsche Bank had confirmed plans to cut 18,000 jobs.
The share price of the parent of Nomura Securities International, Nomura Holdings, had also been slumping in the first three-quarters of 2019, reaching $3.25 at the end of August. Then, on November 8, 2019 Nomura and Deutsche Bank, along with numerous employees, were convicted in a trial in Italy involving helping the Tuscan bank, Monte dei Paschi di Siena, commit fraud in derivatives deals to help it hide losses.
That made the Wall Street firms that were derivative counterparties to the two firms ever more anxious and fearful of extending loans to them in the repo market. And since no one on Wall Street had granular details on which other firms were major counterparties to Nomura and Deutsche, everyone backed further away from each other.