The Truth Will Scare You

Discussion in 'Economics' started by ByLoSellHi, Sep 20, 2008.

  1. Disclaimer - I didn't understand CDS's that well before, and although I now think I have a basic conceptual grasp of them, have much more to learn.

    In the midst of my anger over the nationalization of key sectors of our economy, and the refusal of all politicians and their lackeys to let the free market cut out the cancerous tissue - I came across this excellent (IMO) article, and reading it was cathartic.

    Maybe it will have the same beneficial effect for you.

    The Real Reason Behind the Global Financial Crisis
    by: Money Morning posted on: September 19, 2008 | about stocks: AIG

    By Shah Gilani

    [Part I of a three-part series looking at how so-called “credit default swap” derivatives could ignite a worldwide capital markets meltdown]

    Are you shell-shocked? Are you wondering what’s really going on in the market? The truth is probably more frightening than even your worst fears. And yet, you won’t hear about it anywhere else because “they” can’t tell you. “They” are the U.S. Federal Reserve and the U.S. Treasury Department, and they can’t tell you what’s really going on because there’s nothing they can do about it, except what they’ve been trying to do - add liquidity.

    At the exchange rate Wednesday, 35 trillion British Pounds was equivalent to U.S. $62 trillion (hence, the 35 trillion pound gorilla). According to the International Swaps and Derivatives Association, $62 trillion is the notional value of credit default swaps [CDS] out there, somewhere, in the market.

    This isn’t the first time Money Morning has warned readers about the dangers of credit default swaps. And it won’t be the last.
    The Genesis of a Derivative Boom

    In the mid-1980s, upon arriving in New York from Chicago with an extensive background in trading options and futures (the original derivatives), I was offered a job at what was then Citicorp [today’s Citigroup Inc. (C)]. The offer was for an entry-level post in the bank’s brand new OTC (over-the-counter, meaning not exchange traded) swaps and derivatives group. When I asked what the economic purpose of swaps was, the answer came back: “To make money for the bank.”

    I declined the position.

    It used to be that regulators and legislators demanded theoretical, empirical, and quantitative measures of the efficacy of new tradable instruments being proposed by exchanges. What is their purpose? How will they benefit the capital markets and the economy? And, what safeguards will accompany their introduction?

    Not any more. In the early 1990s, in order to hedge their loan risks, J. P. Morgan & Co. [now JPMorgan Chase & Co. (JPM)] bankers devised credit default swaps.

    A credit default swap is, essentially, an insurance contract between a protection buyer and a protection seller covering a corporation’s, or sovereign’s (the “referenced entity”), specific bond or loan. A protection buyer pays an upfront amount and yearly premiums to the protection seller to cover any loss on the face amount of the referenced bond or loan.
    Typically, the insurance is for five years.

    Credit default swaps are bilateral contracts, meaning they are private contracts between two parties. CDSs are subject only to the collateral and margin agreed to by contract. They are traded over-the-counter, usually by telephone. They are subject to re-sale to another party willing to enter into another contract. Most frighteningly, credit default swaps are subject to “counterparty risk.”

    If the party providing the insurance protection - once it has collected its upfront payment and premiums - doesn’t have the money to pay the insured buyer in the case of a default event affecting the referenced bond or loan (think hedge funds), or if the “insurer” goes bankrupt (Bear Stearns was almost there, and American International Group Inc. (AIG) was almost there) the buyer is not covered - period. The premium payments are gone, as is the insurance against default.

    Credit default swaps are not standardized instruments. In fact, they technically aren’t true securities in the classic sense of the word in that they’re not transparent, aren’t traded on any exchange, aren’t subject to present securities laws, and aren’t regulated. They are, however, at risk - all $62 trillion (the best guess by the ISDA) of them.

    Fundamentally, this kind of derivative serves a real purpose - as a hedging device. The actual holders, or creditors, of outstanding corporate or sovereign loans and bonds might seek insurance to guarantee that the debts they are owed are repaid. That’s the economic purpose of insurance.

    What happened, however, is that risk speculators who wanted exposure to certain asset classes, various bonds and loans, or security pools such as residential and commercial mortgage-backed securities (yes, those same subprime mortgage-backed securities that you’ve been reading about), but didn’t actually own the underlying credits, now had a means by which to speculate on them.

    If you think XYZ Corp. is in trouble, and won’t be able to pay back its bondholders, you can speculate by buying, and paying premiums for, credit default swaps on their bonds, which will pay you the full face amount of the bonds if they do actually default. If, on the other hand, you think that XYZ Corp. is doing just fine, and its bonds are as good as gold, you can offer insurance to a fellow speculator, who holds the opinion opposite yours. That means you’d essentially be speculating that the bonds would not default. You’re hoping that you’ll collect, and keep, all the premiums, and never have to pay off on the insurance. It’s pure speculation.

    Credit default swaps are not unlike me being able to insure your house, not with you, but with someone else entirely not connected to your house, so that if your house is washed away in the next hurricane I get paid its value. I’m speculating on an event. I’m making a bet.

    The bad news is that there are even worse bets out there. There are credit default swaps written on subprime mortgage securities. It’s bad enough that these subprime mortgage pools that banks, investment banks, insurance companies, hedge funds and others bought were over-rated and ended up falling precipitously in value as foreclosures mounted on the underlying mortgages in the pools.

    What’s even worse, however, is that speculators sold and bought trillions of dollars of insurance that these pools would, or wouldn’t, default! The sellers of this insurance (AIG is one example) are getting killed as defaults continue to rise with no end in sight.

    And this is only where the story begins.
    The Ticking Time Bomb

    What is happening in both the stock and credit markets is a direct result of what’s playing out in the CDS market. The Fed could not let Bear Stearns enter bankruptcy because - and only because - the trillions of dollars of credit default swaps on its books would be wiped out. All the banks and institutions that had insurance written by Bear would not be able to say that they were insured or hedged anymore and they would have to write-down billions and billions of dollars in losses that they’ve been carrying at higher values because they could say that they were insured for those losses.

    The counterparty risk that all Bear’s trading partners were exposed to was so far and wide, and so deep, that if Bear was to enter bankruptcy it would take years to sort out the risk and losses. That was an untenable option.

    The Fed had to bail out Bear Stearns.

    The same thing has just happened to AIG. Make no mistake about it, there’s nothing wrong with AIG’s insurance subsidiaries - absolutely nothing. In fact, the Fed just made the best trade in its history by bailing AIG out and getting equity, warrants and charging the insurance giant seven points over the benchmark London Interbank Offered Rate [LIBOR] on that $85 billion loan!

    What happened to AIG is simple: AIG got greedy. AIG, as of June 30, had written $441 billion worth of swaps on corporate bonds, and worse, mortgage-backed securities. As the value of these insured-referenced entities fell, AIG had massive write-downs and additionally had to post more collateral. And when its ratings were downgraded on Monday evening, the company had to post even more collateral, which it didn’t have.

    In short, what happened in one small AIG corporate subsidiary blew apart the largest insurance company in the world.

    But there’s more - a lot more. These instruments are causing many of the massive write-downs at banks, investment banks and insurance companies. Knowing what all this means for hedge funds, the credit markets and the stock market is the key to understanding where this might end and how.

    The rest of the story will be illuminated in the next two installments. Next up: An examination of the AIG collapse, followed by a look at how bad things could get, and what we can do to fix the problem at hand. So stay tuned.
  2. pma


    Holy smokes-I had no idea this was going on. Thanks for the article.:eek:
  3. man


    i have two different opinions on CDS. corporates issue
    bonds to raise money without giving away equity. a
    bond buyer (protection seller) provides the money. which
    means he bets on the ability of the entity to pay back,
    and receives a fee for that. a CDS is very similar, with
    one big difference: it is done between two parties other
    than the corporation. so the entity itself does not profit
    from the willingness of one party to take the risk (sell
    protection). so the CDS is in terms of "real" economy ...

    having said that, there is the argument from the banks,
    that they can offset risk from their balance sheet and
    are more flexible again. the risk is spread over more
    institutions, which provides more liquidity, which is
    essentially good again for the entity, because there is
    a more liquid market for its debt in form of CDS ... and
    consequently to the issued bods as well.

    now, there is a flaw in there: why does bank buy the
    real bonds in the first place, if they do not want to
    have it on their book? simple answer: they seek to
    make a margin sitting in between the bond seller and
    the CDS buyer.

    the real problem with CDS as with most swaps, is that
    they move much less capital than an actual bond sale.
    so ... miss leverage enters the stage.

    i believe, and that is my argument in favor of CDS,
    that CS make sense, as do futures. remember a
    futures contract is abstract (only 1% or so end in
    physical delivery), highly leveraged instrument. it is
    the same as a forward, but unlike the forward it is
    highly standardized and trades on an exchange, which
    gives a lot of liquidity. futures play an important part
    for the "real" economy. but futures are no swap, they
    require down payment of margin and are subject to
    margin calls. they essentially allow less leverage. i am
    not sure if this is actually true, i do not know studies
    on it, but i assume it is like that.

    CDS would make sense if they would trade similar
    to futures. but here is the difficulty: it is the standardization,
    which makes futures liquid and i am not sure if CDS
    can achieve that.

    long post ...
  4. Long but good.

    You know more about CDSs than I ever did.
  5. The Wall Street Model: Unintelligent Design

    Wall Street is collapsing not because of bad mortgage debt or lack of capital or over-leverage. Those are merely symptoms. Wall Street is collapsing because it deserves to collapse; it needs to collapse in order for America to survive. The economist Joseph Schumpeter called it creative destruction, a system where outdated models collapse to make room for new innovation.

    Wall Street of the past decade never really had a business model as much as it had a business creed: greed is good; leveraged greed is even better.

    The fact that Wall Street is collapsing is a given. How it survived as long as it did under its corrupted model is the question that will be debated in history books for the next generation.

    For example, imagine a business model that bases remuneration to brokers on how much money they make for their Wall Street employer and not one dime for how well their customers’ portfolios perform. A Wall Street broker receives remuneration that rises from approximately 30 to 50 per cent of the gross commission based on their cumulative trading commissions with zero regard to how well the clients’ accounts have done. There is no acknowledged internal mechanism in any of the major Wall Street firms to gauge the overall success of the accounts the broker is managing.

    The industry has been irreconcilably incentivized to corruption just as brokers have been socialized to silence. The reason we are seeing a stampede this week into U.S. Treasury securities is that much of this money belonged there in the first place, not in esoteric mortgage backed securities, junk bonds, commodity funds or annuities backed by AIG. Brokers put their clients “safe money” in these unsuitable investments because their Wall Street employer dangled a seductive financial inducement. A broker receives less than $1,000 in gross commissions (“gross” meaning before their firm takes their 50 to 70 per cent cut) on $100,000 of longer dated Treasuries. Putting that same $100,000 in a junk bond or mortgage-backed security or annuity could generate $3,000 or more. In other words, the financial incentive has created an artificial demand. And, as must inevitably happen, the true state of that demand is just now catching up with the true glut of supply.

    What would be the incentive for Wall Street firms to offer higher commissions for some products over others? Because on top of their cut of the brokers commissions, they receive origination and syndication fees for the more esoteric investment products. These firms so despised the low-paying Treasuries that they replaced Treasuries with Freddie Mac and Fannie Mae paper in mutual funds bearing the name “U.S. Government Fund.” (This misleading practice and the fact that billions of dollars of public money resided in these misnamed funds has certainly played a role in the government’s decision to nationalize Freddie Mac and Fannie Mae.)

    Then there is the insane model of bringing flim-flam new businesses to market. If we look at the people who are at the helm of today’s collapsing Wall Street, they have shifted in their chairs, but they are mostly the same conflicted individuals who brought America the NASDAQ bust that began in March 2000 and evaporated $7 trillion of American wealth. There is no longer any incentive on Wall Street to bring about initial public offerings of only companies that will stand the test of time and create new jobs and new markets to make America strong and globally competitive. There is only an incentive to collect the underwriting fee and cash out quickly on private equity stakes.

    Next is the corrupted model of housing a trading desk for the firm inside the same company that is supposed to issue unbiased research to the public. For example, let’s say that XYZ Brokerage buys a big stake in ABC Company on its proprietary trading desk (the desk that trades for profits for the firm) on Wednesday afternoon. On Thursday afternoon, it could almost guarantee profits for itself by issuing a research report upgrading the stock. Conversely, it could short the stock on Wednesday and issue a negative report to drive down the price on Thursday, also guaranteeing itself a profit. Other than a fictional Chinese Wall, there is absolutely nothing to stop this type of public looting.

    Now, ask yourself this. With the multitude of other ways that Wall Street has to make money, why are they allowed to have their own trading desk while simultaneously issuing conflicted research to the public. After the NASDAQ scandals that revealed Wall Street issuing biased research for personal profit, why weren’t proprietary trading desks and public research issuance shut down at these firms. There are plenty of boutique research firms to fill the void. The only conclusion to be drawn is what Europe is calling “regulatory capture” here in the U.S. That’s a phrase similar to what Nancy Pelosi was calling “crony capitalism” on Wednesday, September 17 before she decided to join the crony capitalists at a microphone on Thursday, September 18 to promise bipartisanship on the mother of all bailouts to Wall Street.

    This unintelligent design business model would have cracked and imploded long ago but for one saving grace: it came with its own unintelligent design justice system called mandatory arbitration. Gloria Steinem once called mandatory arbitration “McJustice.” It’s really more like Burger King; Wall Street can have it their way. In a system designed by Wall Street’s own attorneys, arbitrators do not have to follow the law, or legal precedent, or write a reasoned decision, or pull arbitrators from a large unbiased pool as is done in jury selection. Industry insiders routinely serve over and over again. Had there been ongoing trials in open, public courtrooms, the magnitude of the leverage, worthless securities, and corrupted business model would have been exposed before it brought America to the financial brink.

    That Wall Street and its Washington coterie are stilled embraced in regulatory capture and unintelligent design is most keenly evidenced by the recent merger of Merrill Lynch, the brokerage/investment firm, with Bank of America, the commercial bank and ongoing discussions to merge Morgan Stanley, the brokerage/investment firm with a commercial bank. (Memo to Enemy Combatants Against Taxpayers a/k/a Wall Street/Washington: this new model is the failed model of Citigroup. Why do you hate America?)

    Make no mistake that what ever the dollar amount announced next week to funnel into an entity to buy bad debts from banks and Wall Street firms, it won’t be enough. It’s a Band-Aid on a malignant tumor. That tumor is Credit Default Swaps (CDS) with over $60 trillion now owed through secret contracts in an unregulated market created, financed and owned by the unintelligent design masters, Wall Street firms themselves. (See “How Wall Street Blew Itself Up,” CounterPunch, January 21, 2008.)

    There is no sincere plan by this administration to help America or Americans. There is only a plan to slow the financial collapse until after the November elections by throwing a politically palatable amount of money at it and a plan to continue to blame it on a housing bust.

    If we, the American people, allow this to happen, we’re enablers to the unintelligent design model. Before one more penny of our taxes are spent on this ruse, we must demand a seat at the table (I think Ralph Nader should occupy that seat) to discuss breaking up Wall Street, crushing this model, innovating a sensible model that serves the individual investor and deserving businesses, and promises our children a future of more than a banana republic.
  6. CDS's are simple really. I can buy the insurance policies on all the houses on my block and then burn them and get rich... the original owner of the house had a reason not to burn it but I don't.

    The situation is also a lot like what led up to WWI, there were lots of secret defense pacts, when one shitty little conflict broke out into a shitty little war the entire world was obligated to jump in and start killing each other...

    It's Hegelian philosophy at work, create a crisis, use it to gain political power...

    the big question in my thinking is will there be a futures market when the dust settles...... futures are derivatives and in their haste the people that are supposedly solving things currently are limiting short selling and going overboard in all sorts of ways, will they screw up the futures markets for the little guys... I could always trade stocks, I'd be substituting weekly bars for five minute ones likely in order to have the necessary liquidity... as it was in 1932. The dang Dow industrials average daily chart of 1932 looks like a thinly traded stock of today, it's really raggedy looking. Lots of the research of the next few decades was done on weekly bars after 1932...

    I'm boning up on Square Foot Gardening, a book on how to grow veggies really easily, we have a house paid for so not much worries there unless the socialists declare that anybody in need can take from anybody that has something... which they want to do, it would be the last assault on the American Protestants..... anybody but Obama, that is my current motto.....
  7. wojo3423


    The Bush administration seeks ``dictatorial power unreviewable by the third branch of government, the courts, to try to resolve the crisis,'' said Frank Razzano, a former assistant chief trial attorney at the Securities and Exchange Commission now at Pepper Hamilton LLP in Washington. ``We are taking a huge leap of faith.''

    WE ARE FUCKED!!!!!
  8. TD23


    If Bear Stearns would have collapsed then the biggest loser would have been J.P. Morgan, because it was due to pay ridicules amount of money in CDS coverage and it was highly leverage.
    The fact that the FED guaranteed the loan made sure that the risk went down significantly and J.P. Morgan was saved.
    Bear Stearns was just a smoke screen for the bigger player – J.P. Morgan.
  9. Yes, yes, oh yes, its all greed, greed & greed & conspiracy & Wall Street fat cats.. which means that all the losers and 'have-nots', thats many at ET, can go to bed at night, feeling good about themselves going nowhere. :eek:
    #10     Sep 21, 2008