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!"
The gears of the machine? Where are they now?
there was no BOOM for most of us....maybe if you were heavily invested in the stock market but most people are not.....
and as it turns out, more and more of those "gains" were based on an illusion....
everything bad started with Clinton...
50 trillion dollars... where in the world is 50 trillion dollars?
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They are inventing money.
Isn’t that the domain of the Treasury?
One difference — the Treasury has to follow laws and regulations and such.
Finally someone telling it like it is. We are in that much debt. The subprimes were just the trigger. If we pour more debt on watch out. The whole thing will unravel.
It’s like the government is running itself.
Where were the politicians?
be careful, now!
bill o’reilly said just friday in a tirade that
clinton administration was not involved and was being unfairly blamed by “right wingers”.
/s
I don't know. But I assure you, I am not interested in paying that money. Let these banks, insurance companies, and hedge funds, take the loss, otherwise they will do it again.
Only bank depositers should be guaranteed. They can have a govt guarantee, perhaps in a newly set up national bank, if needed, and the rest must just be left to market forces.
Stinks to high heaven doesn’t it!!!
We have to just let it all crash down, I’m afraid, and simply start all over from bedrock honest priciples.
If I’m wrong, and the best thing is to rescue the addicts, it seems all we are doing by bailing out and band-aiding the catastrophe is perpetuating the socialist boondoggle that will nonetheless come to a day of reckoning, a collapse sooner or later.
Why not get back to basics now? If it means millions living in hobo camps for awhile, maybe it’s what we have to go through to sober up and stop the shell-game.
Heaven forbid, are you suggesting that the gods of wall street actually follow laws, they are only for the little people you know. LOL
I do believe that is the way it is currently set up. I agree 1000%.
ping for later
They sure aren’t with the people. They are greedy and they just don’t care if they destroy America or not.
If they bailout, it will unravel. They need to take that money and pay down the debt.
Bank of International Settlements states total notional credit derivative instruments world wide are over a QUADRILLION noww...most fantastic destructive bubble in all history. The credit default swaps, big enough to sink us, are only around $60 trillion. Here is an excerpt from a couple of months ago from Jim Sinclair of www.jsmineset.com on derivatives..
“The notional value of all outstanding derivatives now totals approximately $1.144 QUADRILLION.
This appears to be Bank of International Settlement Spin to announce the largest gain in derivatives outstanding since they started to report. As of the last report it appeared that both listed and OTC derivatives was under $600 trillion. Now listed credit derivatives alone stood at $548 Trillion. The OTC derivatives are shown as $596 billion notional value, as of December 2007. One can only imagine what number they are at now.
Well we hit a QUADRILLION. We have more than $1000 trillion dollars in all derivatives outstanding. That is simply NUTS because notional value becomes real value when either counterparty to the OTC derivative goes bankrupt. $548 trillion plus $596 trillion means $1.144 quadrillion.
It would be an interesting piece of research to see what the breakdown is of listed derivatives according to exchange to see if it adds up to the reported number. Spin is now everywhere.
This means that no OTC derivative house can be allowed to go broke. This means that whatever funds are required to rescue failing international investment banks, banks and financial entities will be provided.
Keep this economic law in mind. Monetary inflation proceeds price inflation and is its primary cause in economic history from Rome to present.”
Wow. I am sick.
There will soon be major geo-political shifts.
Sooo... what happened to the insurance they paid a small premium on?
I’m going out on a limb and blaming Greenspan and Rubin.
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