Credit Default Swaps - Derivative Disaster Du Jour

When the smartest guys in the room designed their credit default swaps, they forgot to ask one thing - what happens if the counterparties do not have the money to pay? Credit default swaps (CDS) are a form of derivative used to hedge exposure to credit. They are sold as "insurance" against default and are used by banks as a substitute for adequate capitalization. But CDS are not ordinary insurance. Insurance companies are regulated by the government, with the requirements, statutory limits, and examiners routinely showing up to check the books to make sure the money is there to cover potential claims. CDS are private bets, and the Federal Reserve from the time of Alan Greenspan has insisted that regulators leave hands. The sacrosanct free market would supposedly regulate itself. The problem with this approach is that regulations are just rules. If there are no rules, the players can cheat and have cheated a typical dependence of the gambler. In December 2007, the Bank for International Settlements reported that the derivatives market was record $ 681 trillion - ten times the GDP of all countries of the world combined. Somebody is obviously bluffing about the money being brought into play, and that realization has made for some very jittery markets.

CDS have been called "the derivative disaster du jour", following the CDO (collateralized debt obligations, SIV (structured investment vehicles), and other obscure financial acronyms that we have learned over the last year. The idea of ​​derivatives it is strange that one is quite difficult to understand, but the basic idea is that you can insure an investment you want to go up by betting it will go down The simplest form of derivative is a short sale:. you can place a bet that some assets you own will go down, so that you are covered in any way the moves of the activities. Credit default swaps are the most common form of trade credit derivative. These bets between two parties on whether or less a company will default on its bonds. In a typical default swap, the "protection buyer" gets a large payoff if the company defaults within a certain period of time, while the "protection seller" collects periodic payments for assuming the risk of insolvency. CDS thus resemble insurance policies, but there is no requirement to hold any asset or suffer any loss for which they are widely used just to speculate on market changes. In one example bloggers, who want a hedge fund increase its profits could sit back and collect $ 320 000 per year in premiums just for selling "protection." on a risky BBB junk bond premiums are "" free money - free until the bond becomes insolvent, when the 'hedge fund could be on the hook for $ 100 million in credits and there's the catch:. what happens if the hedge fund has no money? The corporate shell or limited partnership is put into bankruptcy, but that hardly helps creditors.

Derivative "insurance" was held to look more like fraud insurance, and that fact has particularly hit home with ratings downgrades of the insurers "monoline" bond insurers and the recent collapse of Bear Stearns. Monoline insurers are the biggest protection writers for CDS, and Bear Stearns, a major Wall Street investment banking, was the twelfth largest counterparty to the trade of credit default swaps in 2006. These players have all been the largest sellers of "protection" in a massive web of credit default swaps, and when the "protection" goes, the whole fragile derivative pyramid will go with it. But the imminent and inevitable collapse of the derivative monster should not be cause for despair. The $ 681 trillion derivatives trade is the last supersized bubble in 300 years of pyramid scheme, which has now taken over the entire monetary system. The nation's wealth has been drained into private vaults, leaving scarcity in its wake. It is a corrupt system, and the change is long overdue. Only when the old ship goes down it loses something better can replace it. Major crises are major opportunities for change.

"THE DERIVATIVES CHERNOBYL"

The restructuring of Bear Stearns over the weekend on St. Patrick's Day was a direct blow to the bank from the derivatives iceberg Titanic. Bear Stearns helped fuel the explosive growth of credit derivatives market, where banks, hedge funds and other investors have committed $ 45 trillion worth of bets on the creditworthiness of companies and countries. In 2006, Bear was the twelfth largest counterparty to the trade of credit default swaps. On March 14, Bear ratings have been downgraded by Moody, and March 16, Bear was acquired by JPMorgan for pennies on the dollar, a token buyout designed to avoid the legal complications of bankruptcy. The agreement was supported by a $ 29 billion line of credit the Federal Reserve. How to put a title, "Fed's Rescue of Bear Halted Derivatives Chernobyl." Bear has been involved in a sum of $ 13,000 billion in derivatives trades. [Cite] But the idea that Bear was "rescued" or that the Chernobyl was halted by the Fed's rescue plan was grossly misleading. The CEOs managed to salvage their stunning bonus, but it was a "bailout" only for JPM and Bear's creditors. For shareholders, it was a wipeout. Their stock initially dropped from $ 156 to $ 2 per share, and 30 percent of it was held by employees. Another big chunk of it was owned by pension funds of teachers and other public officials. The share price was later raised to $ 10 per share in response to shareholders, but shareholders were essentially wiped out. And the fact that a bank on Wall Street had to be thrown to the lions to rescue the others hardly inspires a feeling of confidence. Neutron bombs are not so easily contained.

The Bear Stearns hit from the derivatives iceberg followed an earlier one in January, when global markets took their worst tumble since September 11, 2001. Commentators were asking if this was the "big one" - a 1929-style crash - and probably would have been if deft market manipulations had not swiftly covered over the approaching catastrophe. The precipitous drop was blamed on the threat to downgrade the ratings of two major monoline insurers Ambac and MBIA, followed by a loss of $ 7.2 billion in derivatives markets at Societe Generale, France's second largest bank. The "monoline" are so called because they are authorized to "guarantee" a single industry, the bond industry. Like Bear Stearns, serving as counterparties in a web of credit default swaps, and a downgrade in their ratings would jeopardize the whole shaky derivatives edifice.

The collapse in international markets in January occurred on Martin Luther King Day, when U.S. markets were closed. This meant that there was no Federal Reserve, no business channel CNBC, no Plunge Protection Team on duty to turn away the plague. The team was obviously at work the next day, when the market suddenly reversed course, but the tent was thrown back long enough to see what the future might bode. The Plunge Protection Team is a team of experts assembled by Presidential order to specifically manipulate the markets. Formally called the President's Working Group on financial markets, including the President, the Secretary of the Treasury, the Federal Reserve chairman, the chairman of the Securities and Exchange Commission, and the chairman of the Commodity Futures Trading Commission. If ever there was any lingering doubt about the fact that a team is actually in action in these situations, it was dispelled by a statement of Senator Hillary Clinton reported the State News Service January 22, 2008. He said:

"I think it is essential that the next step to be taken. The President should have already and should do so very quickly, convene the President's Working Group on Financial Markets. This is something he can ask the Secretary of the Treasury to do .... This must be coordinated across markets with the regulators here and obviously with regulators and central banks around the world. "

The market reversed on rumors of a $ 15 billion bailout of the monoline insurers besieged by the banks that were going to lose the most if it went down. But no bailout materialize during the next month, and even then, 15 billion was clearly not enough to save the monolines. Analysts said the insurers in trouble may need up to $ 200 billion to remain viable. They also warned that investors would face huge writedowns on the valuation of securities guaranteed by the insurers, if they have lost their honors credit. Insurers "insured" securities with credit default swaps, thinking it would never actually pay. What has worked for municipal bonds have traditionally guaranteed as municipal bonds rarely default. The failure of the monoline was branching out into securitized mortgage debt. When the housing market turned, defaults are cascading around the world.

On February 22, 2008, after a bad week in U.S. markets, rumors of a bailout has caused the sudden stock market to reverse again, but once the rumors were suspicious. Bill Murphy wrote in his market commentary running "Midas", "My guess is that they were looking at another Asian potential collapse Sunday night, and will do anything to avoid the abyss." The due date passed and no rescue was announced, and when a resolution was finally announced, it was just for Ambac to raise a further $ 1.5 million of capitalized by issuing stock. But the PPT had done its job in creating the illusion necessary to restore "market confidence", and probably will not hear anything on the downgrade of monoline insurers, especially now that the Federal Reserve needs them "triple A" Veneer justify the assumption of subprime debt as collateral for the deal Bear Stearns.

Institutional investors have lost a lot 'of money in all this, but the real calamity is to the banks. Institutional investors that formerly bought mortgage-backed bonds stopped buying them in 2007, when the housing market slumped. But the big investment houses that sell them have a value of billions of their books to the left, and it is these banks that are particularly important to lose as the derivative Chernobyl implodes. Without triple-A monoline insurers' seal, billions of dollars of investment will triple A to junk bonds, and since many institutional investors have a legal duty to invest in only the "safest" triple-A bonds, downgraded bonds get downloaded on the market, putting at risk the banks still hold billions of dollars of them. The collapse of Ambac in January, the signal of simultaneous downgrade of bonds from over 100,000 municipalities and institutions, totaling more than $ 500 billion dollars.

A parade of the financial rescue

Now that some of the most influential banks and hedge funds have had to lay their cards on the table and expose their worthless hands, these avid free marketers are crying out for government intervention to save them from monumental losses, while preserving the monumental gains raked in when their bluff was still good. In response to their cries, the men behind the curtain have scrambled to devise various bailout plans, but plans are bandaids at best. To save a $ 681 trillion derivative scheme with taxpayer money is obviously impossible. As Michael Panzer observed on SeekingAlpha.com site:

"As the slow-motion train wreck in our financial system continues to unfold, there will be a lot of ill-conceived rescue attempts and dubious turnaround plans, as well as propagandizing, dissembling and scheming by banks, regulators and politicians. This is all happening in an effort to try to gain time or understand how the losses can be dumped onto the lap of some patsy (eg, the taxpayer). "

The idea seems to be to keep the violins playing while the Big Money Boys slip into the mist and man the lifeboats. As was noted in a blog called "Jesse Café Americain" concerning the bailout Ambac:

"It seems that the real heart of the problem is that AMBAC was being used as a" cover "by the banks that originated these bundles of mortgages to get their assessments lowered. Now that the mortgages are failing and the banks are stuck with them, AMBAC can not pay, can not cover the debt. And the banks do not want to mark these CDOs [collateralized debt obligations] to market [downgrade them to the real market value] because probably at best worth 60 cents on the dollar, but are held by banks in an equal relationship. This is a 40 percent haircut on enough debt to sink every bank involved in this situation .... Indeed for all intents and purposes if market banks are now insolvent . so, banks will provide capital to AMBAC ... [but] it's just a game of passing money around .... So why are the banks engaging in this charade? This looks like an attempt to extend payments on a vast Ponzi scheme gone bad that is starting to collapse .... "

The Wall Street Ponzi scheme

The Ponzi scheme that has gone bad is not just another misguided investment strategy. And 'in the heart of the banking business, the thing that has supported over three centuries. A Ponzi scheme is a form of pyramid scheme in which new investors must continually be sucked in at the bottom to support the investors at the top. In this case, new borrowers must continually be sucked in to support the creditors at the top. The Wall Street Ponzi scheme is based on "fractional reserve" lending, which allows banks to create a "credit" (or "debt") with accounting entries. Banks are now allowed to lend from 10 to 30 times their "reserves," essentially counterfeiting the money they lend. Over 97 percent of the U.S. money supply (M3) has been created by banks in this way. The problem is that banks create only the principal and not the interest necessary to repay their loans, so new borrowers must continually be found to take out new loans just to create enough "money" (or "credit") to service the old loans composing the money supply. The struggle to find new debtors has gone on for over 300 years - since the founding of the Bank of England in 1694 - until the whole world has become mired in debt with the money monopoly of the bankers' private. The Ponzi scheme has finally reached its mathematical limits: we are "all borrowed up."

When the banks ran out of creditworthy borrowers, they had to turn to non-creditworthy "subprime" borrowers, and to prevent leakage of default, they moved these risky mortgages off their books by bundling them into "securities" and selling them to investors. To induce investors to buy, these securities were then "insured" with credit default swaps. But the housing bubble itself was another Ponzi scheme, and eventually there were more borrowers to be sucked into the bottom who could afford the ever-inflating home prices. When the subprime borrowers quit paying, the investors quit buying mortgage-backed securities. The banks were then left with the suspicion his card, and without triple-A rating, there is little chance that buyers for this "junk" will be found. The crisis is not, however, the economy itself, which is fundamentally sound - or would be with a proper credit system to oil the wheels of production. The crisis of the banking system, which can no longer cover the game it has played for three centuries with other people's money.

The banks therefore no doubt be looking for a bailout after another from his pocket only the deepest of them, the U.S. government, but if the federal government agrees, it may be too drawn into the vortex of debt and the mortgage mess . The federal government has a triple A rating is already in jeopardy, because of its huge $ 9 trillion debt. Before the government agrees to bail out banks, should insist on some adequate quid pro quo. In England, the government agreed to bail out bankrupt mortgage bank Northern Rock, but only in exchange for shares of the bank. On March 31, 2008, The London Daily Telegraph reported that Federal Reserve strategists were eyeing the nationalizations that saved Norway, Sweden and Finland from a banking crisis from 1991 to 1993. In Norway, according to one Norwegian adviser, "The law was amended in order to take control of 100 percent of any bank where its equity had fallen below zero."

SOLUTION Benjamin Franklin

Nationalization has traditionally had a bad name in the United States, but the solution might actually be an attractive alternative for the U.S. government. Turning bankrupt Wall Street banks into public institutions might allow the government to get out of the debt cyclone by the trouble in it. Instead of robbing Peter to pay Paul, flapping around in a sea of ​​debt trying to stay afloat by creating more debt, the government could address the problem at its source: it could restore the right to create money to Congress, the ' public body to which that solemn duty was delegated under the Constitution.

The most brilliant banking model in our national history was established in the first half of the eighteenth century, in Benjamin Franklin of Pennsylvania. The local government has created a "land bank" (money-issuing bank apparently supported by the ground), which lent money to farmers a modest interest. The provincial government created enough extra money to cover the interest not created by loans, spending it in the financing of public services. The bank was publicly owned land, and the bankers it employed were public servants. The interest generated on its loans was sufficient to fund the government without taxes, and because the government issued money came back, the result was not inflationary. The banking system of Pennsylvania was a practical and highly efficient, a product of American, but never had the chance to prove itself after the colonies became a nation. It 'was an ironic twist, since according to Benjamin Franklin and others, restoring the power to create their own currency was the main reason the colonists fought for independence. Creation of the money machine of the bankers' has had two centuries of empirical testing and has proven to be a failure. It 's time that the sovereign right to create money to be taken by a private banking elite and restored to the American people.