Shah Gilani writes: 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 yesterday (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.
In the mid-1980s, upon arriving in New York from Chicago with an
extensive background 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. (09/24/08)
more…