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The Oil-Drenched Black Swan, Part 2: The Financialization of Oil

Monday, December 1, 2014 19:04

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All the analysts chortling over the “equivalent of a tax break” for consumers are about to be buried by an avalanche of defaults and crushing losses as the chickens of financializing oil come home to roost.

The pundits crowing about the stimulus effect of lower oil prices on consumers are missing the real story, which is the financialization of oil. Financialization is another word that is often bandied about without the benefit of a definition.

Here is my definition:

Financialization is the mass commodification of debt and debt-based financial instruments collaterized by previously low-risk assets, a pyramiding of risk and speculative gains that is only possible in a massive expansion of low-cost credit and leverage.

That is a mouthful, so let’s break it into bite-sized chunks.

Home mortgages are a good example of how financialization increases financial profits by jacking up risk and distributing it to suckers who don’t recognize the potential for collapse and staggering losses.

In the good old days, home mortgages were safe and dull: banks and savings and loans issued the mortgages and kept the loans on their books, earning a stable return for the 30 years of the mortgage’s term.

Then the financialization machine appeared on the horizon and revolutionized the home mortgage business to increase profits. The first step was to generate entire new families of mortgages with higher profit margins than conventional mortgages. These included no-down payment mortgages (liar loans), no-interest-for-the-first-few-years mortgages, adjustable-rate mortgages, home equity lines of credit, and so on.

This broadening of options and risks greatly expanded the pool of people who qualified for a mortgage. In the old days, only those with sterling credit qualified for a home mortgage. In the financialized realm, almost anyone with a pulse could qualify for one exotic mortgage or another.

The interest rate, risk and profit margins were all much higher for the originators. What’s not to like? Well, the risk of default is a problem. Defaults trigger losses.

Financialization’s solution: package the risk in safe-looking securities and offload the risk onto suckers and marks. Securitizing mortgages enabled loan originators to skim the origination fees and profits up front and then offload the risk of default and loss onto buyers of the mortgage securities.

Securitization was tailor-made for hiding risk deep inside apparently low-risk pools of mortgages and rigging the tranches to maximize profits for the packagers at the expense of the unwary buyers, who bought high-risk securities under the false premise that they were “safe home mortgages.”

The con worked because home mortgages were traditionally safe. Financialization did several things to the home mortgage market:

1. Collateralized previous low-risk assets into high-risk, high-profit financial instruments

2. Commoditized this expansion of debt and leverage by securitizing the exotic mortgages

3. Built an inverted pyramid of leveraged speculative debt on the low-risk home mortgage

4. Used the Federal Reserve’s vast expansion of liquidity and credit to originate trillions of dollars in new debt and leveraged financial instruments.

Consider a house purchased with a liar-loan, no-down payment mortgage. Since the buyer didn’t even put any cash down or verify stable income, there is literally no collateral at all to back up the mortgage. The slightest decline in the value of the home will immediately generate a loss of capital.

Now pile on derivatives, CDOs, etc. on the inverted pyramid of risk piled on the non-existent collateral, and you have the perfect recipe for financial collapse.

Like home mortgages, oil has been viewed as a “safe” asset. The financialization of the oil sector has followed a slightly different script but the results are the same:

A weak foundation of collateral is supporting a mountain of leveraged, high-risk debt and derivatives. Oil in the ground has been treated as collateral for trillions of dollars in junk bonds, loans and derivatives of all this new debt.

The 35% decline in the price of oil has reduced the underlying collateral supporting all this debt by 35%. Loans that were deemed low-risk when oil was $100/barrel are no longer low-risk with oil below $70/barrel (dead-cat bounces notwithstanding).

Financialization is always based on the presumption that risk can be cancelled out by hedging bets made with counterparties. This sounds appealing, but as I have noted many times, risk cannot be disappeared, it can only be masked or transferred to others.

Relying on counterparties to pay out cannot make risk vanish; it only masks the risk of default by transferring the risk to counterparties, who then transfer it to still other counterparties, and so on.

This illusory vanishing act hasn’t made risk disappear: rather, it has set up a line of dominoes waiting for one domino to topple. This one domino will proceed to take down the entire line of financial dominoes.

The 35% drop in the price of oil is the first domino. All the supposedly safe, low-risk loans and bets placed on oil, made with the supreme confidence that oil would continue to trade in a band around $100/barrel, are now revealed as high-risk.

In the heyday of mortgage financialization, exotic mortgages were tranched into securities that were designed to fail, to the benefit of the originators, not the buyers.These financial instruments were sold with the implicit understanding that they were only low-risk if the housing bubble continued to expand.

Once home prices fell and the collateral was impaired, it only made financial sense for borrowers to default and counterparties to refuse to pay until their bets were made whole by another counterparty.

The failure of one counterparty will topple the entire line of counterparty dominoes. The first domino in the oil sector has fallen, and the long line of financialized dominoes is starting to topple. Everyone who bought a supposedly low-risk bond, loan or derivative based on oil in the ground is about to discover the low risk was illusory. All those who hedged the risk with a counterparty bet are about to discover that a counterparty failure ten dominoes down the line has destroyed their hedge, and the loss is theirs to absorb.

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Go to my main site at www.oftwominds.com/blog.html
for the full posts and archives.

Source: http://charleshughsmith.blogspot.com/2014/12/the-oil-drenched-black-swan-part-2.html

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