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January 23, 2008

Move Over Subprime , It's Primetime for Credit Default Swaps

As if, after centuries of debacles, we needed proof that greed and fear will trump rationality in the affairs of men big and small; once again, we are peering down that precipice of folly called "the market knows best". This Gilded Age that even the Enron debacle couldn't derail has now come to crash. And oh, by the way, the rest of us will be left to swab the blood and piece together the remains.

Last month we warned that the second shoe is about to drop as subprimes move off the front pages to make room for something more obscure but potentially even more toxic, called credit default swaps or CDS's. And once again, as with the problem of the subprime mortgage disaster extending far beyond the problem of millions of people unable to make their home payments and the falling home prices of their neighbors but rather to the mountain of three-letter (CDO, CLO, SIV, etc..) financial rigmarole that the banking system and the shadow financial system generated on top of the mortgages, the failure of billions of dollars in CDS's and their derivatives, will rain down on all of us.

Remember, banks in China, Singapore, even a few small towns in Norway and some of the biggest world-straddling financial institutions are all still trying to figure out how much they lost buying the toxic waste their bond development arms so profitably generated in the pyramid scheme that led up to the latter stages of the subprime crash. Financial institution balance sheet losses, alone, are conservatively estimated to be in the range of $250 billion when all the off-book transactions are brought into the open as write downs..

Counterparty, What's a Counterparty?

Unfortunately, as they say on prime time, there's more to come, folks: the credit default swaps --insurance policies with little money behind them-- are whole new episodes still to be played out.  And when it's all done the major economies of the world will have thrown further billions in taxpayer money at the various debacles.  Only the scoundrels who conceived of the pyramid and spread the bets around, will be left with their fortunes intact; for, if we've learned anything at all, we know that the bailouts will be seen as necessary to keep the system from crashing entirely and the guys who walked away and the guys who were supposed to be regulating them will be off laughing, no doubt conspiring on the next bubble.

It might be sobering to note that there are estimated to be $45 trillion in CDS's in circulation as we write this, that, in case you're not counting, amounts to approximately 3 years worth of the entire US economy! CDS's are designed to act as insurance against the default of specific junk bonds, bundles of bonds or, their derivatives, and in a further twist, of the same companies that issued the insurance swaps in the first place. They have existed in a market outside of, but impacting the bond insurance traditionally issued by the monoline companies to guarantee corporate and municipal bonds and the complex rating system that determines the interest rates that companies and municipalities end up paying as they rotate their borrowing sometimes on a weekly or monthly basis.

But as CDS's took off even the sleepy monoline insurance business got a hit of cocaine in the last few years and got into the more lucrative business of using their AAA credit ratings to issue insurance on the CDO's that Wall Street was using to finance the subprime mortgage bubble. As a result nearly all of the major bond insurers (Ambac and MBIA, are the leaders) are now facing bankruptcy, unable to take on the financing needed to cover their obligations without so diluting their capital that takeover vultures will rush in right behind the capital injections.  This is still to be played out as bailouts get structured (here's a Marketwatch article).

In the meantime, with the money spigot left wide open by the Fed, the vast majority of squirrelly bonds issued by Wall Street was "junk" rated and thus out of the realm of the regular insurers --who,  by the way, are also required to keep a certain amount of reserves on their books to back up the insurance or lose their vaunted credit ratings--  and so a whole new range of players stepped in to fill the void with these CDS's.  The issuers, whether hedge funds or off-the-book brokerage house and bank financed companies, created mountains of new paper insuring, as we noted, not only the derivative products but the derivatives that were derived from bundling derivatives (you wonder who would have bought into this game?). These new insurers, or counterparties, as they're called on Wall Street, were totally unregulated, existed outside the realm of the already overly loose playing ratings agencies, and thus had no real obligation, other than their own guarantees, to keep any reserves on hand.  And, of course, as quickly as the hedge funds were able to amass piles of cash, they could disappear as investors smelling the coming debacle, pulled their money out.

Like the subprime mortgages that were issued by people who were paid to write them but who carried no risk should they go bad, the CDS writers and the brokerage houses that moved their paper guarantees had little to worry about and plenty to gain in the short term. The clearest description of what a CDS is came in some of our reading last week.  The author --who will have to go without credit as we forgot to pencil in a note-- called them something akin to side-bets that viewers of a sporting event make between themselves along the side-lines.  CDS's, it turns out, were bought and sold by participants who were not holding the underlying securities that were insured.  In that way they opened the door to speculators who might be trying to short the derivative, junk bond or CDO, etc. markets.

In free market theory all this activity would be beneficial to the overall market as it spreads the risk or at worst, would be detrimental strictly to the players on the wrong side of a bet. 

According to this line of thinking, you've got supposedly shrewd and savvy people managing other supposedly smart, shrewd and savvy people's money making their own bets on how things will play out.  This "hedging" or "speculative" activity, depending on the bettors perspective, is theoretically supposed to allow more granulated approaches to larger market forces thus smoothing out discrepancies that might otherwise disproportionately tilt them. Unfortunately, as we are once again about to see so tragically, it doesn't work that way when the guys who start the pyramid game get to walk away Scot free leaving people who never ever heard of a hedge fund, much less, a CDS to pay the piper!  That's where we are today as markets around the world tumble and the Central Bankers and politicians scurry to print more paper, this time in the form of legal tender, thus diluting everybody.

It's Pay Up Time

The big problem with the CDS's is that losses involving this paper may total another $250 billion or perhaps much more, according to the calculations of people like Ted Seides (see our last piece, The Next Big, Big Crack)  Junk bonds by their very definition, are bonds issued by entities with weak balance sheets.  They pay higher interest because there is a higher probably some of them fail.  Historically, these defaults run in a range, depending on the relative financial health of the issuer,  from about 2.8% to 4.7 % in normal times. With the pool of junk bonds expanding over the last few years in a borrowers market when investors were willing to buy just about anything sporting even a small risk payoff (in fact the premium between Treasury's and junk had never been narrower), there's lots of room for future failure. It's also obvious that in a recession the percentage of failing companies increases significantly and therefore the number of failing bonds increases.  It may, with a deeper than normal recession looming, then be much more that an average failure rate for low rated junk of  4.7% over the next couple of years, if so the losses would be nearly $1/2 trillion just in CDS's. And once again, no one knows who the counterparties are and where they could possibly come up with that kind of money (we can guess with great certainty, they can't) and, more importantly, who is holding all these CDS's that are likely to sink to pennies on the dollar. Imagine the big banks going through another round of hat-in-hand begging for cash injections around the globe.  Any takers for side bets on whether the governments will step in?

Now comes the US recession and an ongoing crisis in the world financial system still trying to swallow the subprime debacle's losses and we can now foresee the failure of numerous junk bond issuers.  As those bonds fail, investors will turn to the CDS issuers to cover the defaults. And, of course, the issuers of those guarantees will be nowhere to be found, their gains tucked handily out of reach in offshore havens that require no reporting and no taxes.  No wonder the Fed and the Treasury Secretary have gone into panic mode!

 Meanwhile, the so-called US or world recession will deepen as the authorities begin to dig deeper and deeper into their rescue strategies. Nobody, except maybe the GOP candidates, will be lauding the free market system as it becomes time to start wiping the blood off the floor.  Stock holders and investors will be the first to be hit but certainly won't be the worst victims of the folly that let $45 trillion in insurance be issued without any reserve requirements.  Interest rates will be forced down affecting older Americans whose incomes are tied to them, families with large credit card debt will default, governments will struggle with lower tax revenues and begin cutting programs designed to protect their taxpayers, good jobs will be lost at an even faster pace then during the "good times' of the last 4 years. As Wall Street insider and serial bull, Mort Zuckerman, so out of character, put it on the weekly John McLaughlin Show, we're looking down the barrel of the worst recession since 1929.

The already wounded large banks will struggle once again to cover the next round of losses brought around by the CDS debacle and new and larger pieces of America will go on fire sale to those private and "sovereign" entities sitting with their coffers stuffed with dollars that have been passing so quickly through Wall*Mart, Exxon, etc. conveyor belts on their way East. The CDS debacle will be this chapter's Black Swan.

That's why nobody thinks the $150 billion stimulus plan proposed by the President with Congress on the bandwagon is going to do more than a peashooter aimed at a tsunami. Just as sharply lower interest rates in the US will only accelerate the race out of the dollar thus fueling a new round  of strange distortions down the road.

Bush, it looks like, will finally get to truly exceed his father. The 2nd Bush Recession, potentially the worst since 1929, on top of the series of debacles around the world of this regime, and a bleeding dollar will put the nail in the coffin of the Reagan Revolution. The party of domestic deficit spending, unfettered trade policies in the face of enormous dollar trade deficits, moving social security money to Wall Street, off the books war spending, and the dogmatic unfettering of the activities of the world's pyramid scheme guys, will likely come to an end.  Already you can see it coming apart as the so-called social conservatives get fleeced at the gas pump on their way to jobs or homes that might not be there next month, the defense hawks contemplate unending $trillion, force-draining occupations of Iraq and Afghanistan and the fiscal conservatives see their savings eaten away by a diluted dollar.

Imagine a country with high unemployment, millions of personal bankruptcies and foreclosures, bailed out banks and brokerages and a social safety net in tatters; now think about the lip licking, fire-sale vultures waiting in the wings to swoop in, who have gotten away with the loot thanks in part to egregious tax loopholes that not even a Democratic congress had the guts to close.  If that doesn't make you mad, nothing will.

Posted by dymaxion at 02:21 PM

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