Posted on 09/27/2008 9:13:31 PM PDT by Porterville
Of all the really bad ideas that have infested the finance business in the last 30 years, the most dangerous is probably the credit default swap (CDS).
CDS is almost a brand new investment vehicle, but the market is already 20 times its size in 2000. The principal amount of CDS outstanding equals $50 trillion, or more than three times the U.S. Gross Domestic Product and bigger than all the U.S. credit markets put together. And the CDS has been a huge source of "financial engineering" profits, both for Wall Street and the hedge fund community over the last few years.
The first true credit default swap was carried out as late as 1995, although various types of credit protection derivatives existed earlier. Its structure is similar to an ordinary interest rate or currency swap transaction, and the CDS market is covered by the International Swaps and Derivatives Association Inc
Under a CDS, a bank originates loan to a company. A second bank (or other financial institution) can agree to cover the credit risk for the loan, by agreeing to make payment to originating bank if the company defaults on the original loan. The originating bank pays a small insurance premium to the second bank for assuming the risk of the loan.
Typically, payments under a CDS would only be triggered by the company’s failure to pay interest or principal on its debts due to bankruptcy or some other severe liquidity issue. But there are a host of intermediate or special cases that will doubtless provoke lawsuits when something goes wrong (CDS being a new market, it is by no means "recession-proof").
Credit default swaps were sold to the world as hedging transactions. Investors were told that they were simply transfers of risk, so that banks that made loans could transfer credit risks to insurance companies, which did not make loans directly, or to foreign banks that could not easily make loans in the U.S. market.
And if an originating bank sells its loan exposure only once, and sells it to a financial firm of undoubtedly solid credit, the CDS does indeed act as a hedge for the originating bank; it transfers the company’s credit risk from the bank to the financial firm that bought its CDS.
But the product did not work as advertised.
Enter the Traders Salesmen and traders took over, and expanded the volume far beyond what was required for hedging.
After all, bonuses depend on the volume of business. Therefore, bank traders sold the credit risk of a loan not just once, but as many as 10 times. And they sold it not to solid banks and insurance companies, but to three solid banks, one solid insurance company, three dodgy brokers and three hedge funds. Then the traders went out and sold other CDS products that were not even related to actual loans on the books, but to imaginary indices of credit quality in the "widget" industry.
The credit risk of the system was hugely multiplied.
Instead of one $10 million credit risk loan, there are now ten $10 million credit risks on just one loan.
•Three on solid banks - but will they stay solid? •One on a solid insurance company - probably OK. •Three on dodgy brokers - who knows? •And three on hedge funds - probably not OK in a real downturn. The total credit risk in the system has been increased from the original $10 million loan to somewhere between $160 million to 200 million, depending on whether the banks and insurance company are financially solid.
Of course, a lot of those credit risks offset each other, so that if the company that took the loan goes bust, the only risk to the bank that sold all those CDS is to the profits it expected to make. But since it probably hedged those positions against others, if the company does go bust, and dodgy brokers and hedge funds stop paying up, the total losses in the system from that company’s credit risk are likely to be a substantial multiple of the original $10 million loan.
But please don’t think I was exaggerating when I said as many as 10 credit default swaps got sold for each loan.
The U.S. commercial loan market is worth about $5 trillion, yet the volume of CDS outstanding is currently no less than $50 trillion. In other words, a huge number of traders, salesmen and quants have been making money off this product, without any real "hedging" rationale at all.
And it all worked fine while the volume of defaults remained low, which is why the market expanded from $2 trillion to $50 trillion between 2000 and 2007.
A Ballooning Problem There are two reasons reason why the CDS market has been able to expand so much beyond the size of the underlying debt markets:
•Banking regulations and the lack of funding requirements for CDS: Banks are required by law to hold a certain amount of capital for loans they make - about 8 cents for every dollar in principle, but there are a number of loopholes that allow it to be less for certain types of loans. But there are very limited capital requirements for CDS, so banks and other CDS market participants can take on much more credit exposure through CDS than they could directly. •A loan must be funded: If you lend someone some money, you have to borrow it or use your own capital. However, if you take on the exact same risk through a CDS transaction, there is no need to put up any money, provided your counterparty will accept your credit risk. For both these reasons, hedge funds have been large participants in the CDS market, because through credit default swaps the funds can take on much more risk (and receive much more in premiums) than their modest cash reserves would normally permit.
Big Defaults, Big Trouble Suddenly home mortgages along with corporate credit and other types of consumer credit are in question and loss rates, which were very low in 2005-06, are soaring.
That spells big trouble for credit default swaps.
If just 10% of CDS underlying risks go bust, somewhere in the financial system there will be $5 trillion in losses.
Yes, there could well be $5 trillion of profits elsewhere in the system, because derivative transactions theoretically balance out. But once defaults start piling up, it’s possible that many of those losses will become real, while the profits simply won’t.
For example, hedge funds that have offered credit protection on risks far in excess of their current capital will quickly be unable to pay claims. Their counterparties will suffer unexpected losses, even though they thought they were protected by a CDS.
There are two sources of likely loss on CDS:
•Default by the underlying borrowers, the companies that originally took out the loans. •And default by the banks or other financial firms that bought the credit default swap - counterparties in the endless chain of banks, insurance companies, hedge funds and general riff-raff that have done these deals. Since the total outstanding balance of the CDS market is $50 trillion, compared with the entire U.S. home mortgage market at about $11 trillion and the subprime part of that market at only $1 trillion, you can see why people are worried.
American International Group Inc. (AIG), the insurance company, lost $7 billion on its CDS portfolio in its fiscal quarter ended November 30, and that was on "super senior" CDS. The losses on this type of investment vehicle can get very big, very quickly. And since CDS are so new, they’re completely untested in a real economic downturn.
The annual cost of credit default swaps based on the Markit CDS Investment Grade North America Index, which had bottomed out at 29 basis points (0.29%) in February 2007, soared to 220 basis points at the time of the Bear Stearns Cos. Inc. (BSC) bailout. The index was recently trading at 147.5 basis points, a significant improvement due to the U.S. Federal Reserve orchestrated rescue of Bear Stearns.
But Bear Stearns CDS were recently trading at 330 basis points, despite the guarantee of its obligations by the first-class credit of acquirer JPMorgan Chase & Co. (JPM), which means that investors are still wary.
If the CDS market itself thinks things are about to go wrong, they almost certainly are.
As Oliver Hardy used to say to Stan Laurel: "Another fine mess you got us into!"
Here is the official Bank of International Settlements credit derivative data for 2007 by class of derivative....these are pdf files, and, take a little time to review...they will astound...http://www.bis.org/statistics/derdetailed.htm
Part of this mess started with Carter (and was exacerbated by Clinton).
I assume the Government has not figured out a way to tax this "money"?
~~"Only Yesterday: An Informal History of the 1920’s" by Fredrick Lewis Allen
Without any hyperbole....
But who is participating in the derivative bubble, and if they made all sorts of funny money on paper, then so what if it never becomes real?
It becomes REAL in a CREDIT CRUNCH when the short interval rollovers cannot be FINANCED...the current crisis...and, the defaulted instruments hidden in level 2 and level 3 statements on bank statements have to be repossessed and, REPORTED AS LOSSES...the potential LOSSES exceed the capital reserves of the banks. All G7 countries are heavy participants in the derivative markets. The $700 billion of the current bailout bill is completely inadequate to prevent the derivative meltdown..relief is only temporary.
Bump for later read
Don’t blame Greenspan. Believe it or not it was Clinton and his risk taking that did it. Greenspan inherited the problem and did the best he could.
Remember Bill Clinton, the man that had Bin Laden and let him go?
It appears that the present mortgage finznce crisis is the tip of the iceberg...
...and this is the iceberg.
And are all these insurers “American” entities?
Anyone? Anyone?
It appears that the present mortgage finznce crisis is the tip of the iceberg...
...and this is the iceberg.
And are all these insurers “American” entities?
Anyone? Anyone?
People are finally beginning to understand. Thank you God...
Folks, protect your families. Get some cash-on-hand that will last you at least one month. Same goes for food.
The elation coming early next week won't last.
“Sooo... what happened to the insurance they paid a small premium on?”
I imagine it is like car insurance. Allstate probably has figured that 1 out of 1000 cars gets totaled every year or something. And they make money by getting $40 from all the 1000 to cover the $30,000 car of the one. (And “keep” $10k).
Same thing here I suppose. Except imagine one of those huge dust-storms in California and 800 cars pile up and wreck.....x10000.
Thanks for the ping. Looks complicated, but absolutely necessary to know ... and to see that others know (especially by November 4th) as well.
Later --
~ joanie
No...and please understand that it is the 'insurers' that get hurt.
This problem will devastate the G7 economies.
My point though, is that if these insurers are not under American law, what is keeping them from just shell gaming and walking away?
You know -- like State Farm Insurance after Katrina.
don’t worry bailout is the answer for everything...
The ‘29 crash bottomed in 1933...it was an ‘L’ shaped depression, interupted by the war, and did not have the confirmed ‘uptick’ until 1947. In the depression the govt, and, the Fed Reserve were not broke..they are now. We were industrialized and could produce labor valued products...no longer. A depression now will be ‘L’ shaped also for a much longer period of time. Since 1971 we have been a ‘debt Capitalist’ economy, meaning that all money in circulation must be borrowed. We cannot borrow very much now or in the future. Hyperinflation will go along with the deflation we are experiencing now. The housing bottom has to occur later than 2011 when the last Alt As peak...along with prime mortgages, a problem 5 times bigger than the sub primes. Outlook, world depression unavoidable...tens and humdreds of trillions in derivative defaults cannot be dealt with by billions. Hedge fund redemptions begin in earnest in Dec., then every quarter to follow. Trillions will be attempted to be redeemed from hedge funds in 2009 to no avail. Hedge funds are completely unregulated worldwide and cannot meet redemption demands. The SECs Cox, notes that regulation of the credit default swap derivatives mus occur IMMEDIATELY (they are about $62 trillion of the worldwide over Quadrillion credit derivative instruments)...lots of luck. Lehman Bros. was the dominant investment bank related to credit default swaps....such swaps are now known to be probably valueless as there is no market if they have to be liquidated. What people do not realize is that Paulsons proposal is to bail out foreign banks also, and that Fortis Bank in England is bankrupting this weekend. The Brit PM Brown is in the US now, if he has not already returned to Britain, requesting $100 billion from Paulson from the Bailout Bill, when passed, to bail out Britains acute need NOW...I do not know the result.
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