Credit Default Swaps: Who Needs 'Em?

You thought the sub-prime mortgage mess was bad. Take a look at credit default swaps (CDSs) - a $45 trillion boondoggle that you've never even heard of. It's an enormous market. Consider the Federal debt - $10 trillion; GDP - $14 trillion; the US stock market - $22  trillion; the entire mortgage market - $7 trillion; the US Treasuries market - $4.4 trillion. The credit default swaps market dwarfs them all! In fact it is not much less than all these markets combined!

Credit default swaps are insurance-like contracts that promise to cover losses on certain securities in the event of a default. They typically apply to municipal bonds, corporate debt and mortgage securities and are sold by banks, hedge funds and others. The buyer of the credit default insurance pays premiums over a period of time in return for peace of mind, knowing that losses will be covered if a default happens. It's supposed to work similarly to someone taking out home insurance to protect against losses from fire and theft. Except that it doesn't. Banks and insurance companies are regulated; the credit swaps market is not. As a result, contracts can be traded — or swapped — from investor to investor without anyone overseeing the trades to ensure the buyer has the resources to cover the losses if the security defaults. The instruments can be bought and sold from both ends — the insured and the insurer. All of this makes it tough for banks to value the insurance contracts and the securities on their books. And it comes at a time when banks are already reeling from write-downs on mortgage-related securities. "These are the same institutions that themselves have either directly or through subsidiaries invested in the subprime market," said Andrea Pincus, partner at Reed Smith LLP. "They're suffering losses all over the place," and now they face potentially more losses from the CDS market.

Credit default swaps suffer from all the same defects as collateralized debt obligations (CDOs) in that no one knows who's responsible for the pay-out in the case someone actually defaults. And there's a lot of defaultin' goin' on. Lordy! Lordy! Just think of mortgage defaults. Lack of regulation, lack of accountability - all the same factors that caused chaos when mortgages were securitized, sliced and diced and sold off to investors. No one knows who's responsible! Who's on first? I dunno. What's on second? Duhhh. Citibank? Now with all the liquidity crises and credit crunches, no one, not Paulson, not Bernanke, is suggest- ing that we reinvoke the Glass-Steagall  Act which would have prevented all of it since with Glass-Steagall mortgages could not have been securitized. Therefore, there would be no mortgage backed securities, no CDOs, no CDSs. Reinvoke Glass-Steagall and all these financial instruments would disappear overnight because they would all become illegal in one fell swoop. But nobody is proposing that. Why? Because they still are intending, once this current crisis is "worked through," to go on fleecing the American public with predatory loans. They intend to continue on their course of turning the US into a three class system: the homeless, the debtor class (the former middle class) and the investor class. The debtor class will be up to its eyeballs in debt starting with student loans followed by auto loans followed by credit card debt followed by mortgage debt.

According to Bill Gross, a fixed income market guru, the size of the credit default swap market is "$43 trillion, more that half the size of the entire asset base of the global banking system." If that is not scary enough he goes on to tell us that "total derivatives amount to over $500 trillion, many of them finding their way"......................well, everywhere.

So it's not just the credit default swaps we're talking about here but derivatives of them as well. Talk about a casino! Some people are betting on investments to succeed. Others are betting on them to fail. The question is: is all this really necessary in order to provide the food, shelter, transportation, communications, entertainment and other basic needs and even luxuries of society. My answer is a resounding NO! None of these financial instruments are necessary. They only contribute to the financial- ization and casinoization of society. They should be done away with if there is any hope for the US to be a decent, humane and prudent society. But that certainly isn't the world view of the wealthy neocons who run this society. Their world view is to create a debtor class who will owe them (the investor class) in perpetuity. It isn't even a question about earned or unearned income, about income from work or income from investments. It's a question of what kind of work and what kind of investments and what kind of predation. I say let the investors get a job. The financialization of the US is ruining the US.

According to Jacki Zehner in the Huffington Post:

Bill Gross is a very senior guy at PIMCO, one of the largest fixed income managers in the world. They boast managing over $700 billion of assets, and in my experience as an ex-Goldman Sachs bond trader, they generally do it very well. Bill has been talking for a while now about the "Shadow Banking System" that has developed, which now dwarfs the traditional banking system. He describes how "our modern shadow banking system craftily dodges the reserve requirements of traditional institutions and promotes a chain letter, pyramid scheme of leverage, based in many cases on no reserve cushion whatsoever." Participants in this shadow banking system are in the business of making money, much like their more regulated cousins. They borrow money, leverage it up, and invest in assets to make a positive spread. Sounds simple, until things start to go wrong in the underlying asset, which of course is what is happening now. At the center of this system is a product little known outside of the world of fixed income traders and investors, called Credit Default Swaps. According to Wikipedia, a "credit default swap (CDS) is a bilateral contract under which two counterparties agree to isolate and separately trade the credit risk of at least one third-party reference entity. Under a credit default swap agreement, a protection buyer pays a periodic fee to a protection seller in exchange for a contingent payment by the seller upon a credit event (such as a default or failure to pay) happening in the reference entity. When a credit event is triggered, the protection seller either takes delivery of the defaulted bond for the par value (physical settlement) or pays the protection buyer the difference between the par value and recovery value of the bond (cash settlement). Credit default swaps resemble an insurance policy, as they can be used by debt owners to hedge against credit events. However, because there is no requirement to actually hold any asset or suffer a loss, credit default swaps can be used to speculate on changes in credit spread. Credit default swaps are the most widely traded credit derivative product. The typical term of a credit default swap contract is five years, although being an over-the-counter derivative, credit default swaps of almost any maturity can be traded. " Now what part of that description did you find the scariest? Was it the fact that this market is $43 trillion according to Gross? Or that all the contracts are based on the CREDIT of the underlying asset? Or the contingent payment based upon a credit event? Or the fact that in most cases the seller can ask for delivery of the defaulted bond? Or that there is no requirement to actually hold any asset or suffer a loss? Each of these questions could take pages and pages to dissect. The whole system is obviously based on the assumption that your counter-party can in fact make good on the trade. That is why banks are moving quickly to check their counter-party risk and shore up margin requirements. The prices of the underlying securities have been going down, making net net, some people winners, and some losers. It is the losers we need to worry about as they need to make good on their part of the trade, but will they have the money, the capital, to do so? ... Given the size of the market, and the lack of transparency as to who owns what, we really have no idea about the financial impact caused by the deterioration of the underlying assets. This is why we care. One can not look at history to help figure this out either, as we have never had so much credit product outstanding. Where we are currently in the credit markets is fresh territory, uncharted waters, the wild west. The system is so complex and interconnected that it is absolutely impossible for anyone, any firm, any anything, to get their arms around it. Smart people are going to figure out a way to make money from this uncertainty, and less smart people are going to lose a lot. Bill Gross is warning of the possibility of financial Armageddon as a result of this financial pyramid scheme, along the same line that George Soros, another billionaire who generally knows what he is talking about, came out about a few weeks ago. Both of these wizards of Wall Street have been known to talk to their position, but that does not mean they are not right.

Phil Gramm could not wait to get rid of Glass-Steagall so Citibank could merge with Travelers' Insurance. The banks could not wait to combine commercial and investment banking. What's the result? A total mess. And all the Fed and the Treasury Department are doing is putting band-aids on it hoping that the dam won't totally burst until the Democrats take over and they can blame it on them!

Comments

[Lori]

[begin quote]
If that is not scary enough [Bill Gross] goes on to tell us that "total derivatives amount to over $500 trillion, many of them finding their way"......................well, everywhere.
[end quote]

Half a quadrillion seems to be a suspiciously large number. $500 trillion divided by 6.7 billion folkx is over $74,000 per capita.

On a lighter note, you start the article by telling us that "the Federal debt [=] $10 trillion; GDP [=] $14 trillion." The difference of $4 trillion split 310 million ways is some $12,900. If someone told me we could pay off this indenture in one year assuming everyone can somehow live on $12,900 a year (as I and no doubt others have), I'd bite.

Or would that tank the GDP or something?