The Dirty Secret Behind our Global Financial Crisis

FWMD

While sub-prime home mortgage defaults have taken most of the blame for the US and worldwide financial crisis, a far larger problem is only now coming into focus. The next crisis is already beginning in the estimated $45 to $62 TRILLION USD market for Credit Default Swaps or CDS. A failure to pay on a mere 10% would cause an economic disaster. Unfortunately, it's guaranteed to happen. You never heard of CDS? Well, it's time to take a look.

The CDS (FWMD or Financial Weapons of Mass Destruction as Warren Buffett once called these and other speculative instruments) was invented in the 1990's by J.P. Morgan Chase Bank. A CDS is an agreement between two counterparties, in which one makes periodic payments to the other and gets promise of a payoff if a third party defaults. The first party gets credit protection, a kind of insurance, and is called the "buyer." The second party gives credit protection and is called the "seller". The third party, the one that might go bankrupt or default, is known as the "reference entity." They are essentially paying for protection and peace of mind, and they don't need to own the security to purchase "insurance" over it. It's like betting on a sports event. You're not playing in the game, but people all over the country are betting on the outcome.

These so called "derivatives" resemble an insurance policy, as they can be used by debt owners to hedge, or insure against a default on a debt. However, because there is no legal requirement to actually hold any asset to back up these bets, they can also be used for speculative purposes.

NO REGULATION

Like many exotic financial products which are profitable in times of easy credit, when markets reverse, as is the case now, in addition to spreading risk, they also amplify risk considerably. A chain reaction of failures in the CDS market could trigger the next global financial crisis. The market is entirely unregulated, and there are no public records showing whether sellers have the assets to pay out if a bond defaults. The Fed bailout of Bear Stearns on March 17, 2008 was motivated in part, by a desire to keep the unknown risks of that bank's CDS from setting off a global chain reaction that might have brought the financial system to its knees.

Insurance companies are regulated by the government, with reserve 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 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.

CDS were seen as easy money for banks when they were first launched more than a decade ago. The economy was booming and corporate defaults were few back then, making the swaps a low-risk way to collect premiums and earn extra cash.

And then came the housing boom. As the Federal Reserve cut interest rates and Americans started buying homes in record numbers, mortgage-backed securities became the hot new investment. Mortgages were pooled together, and sliced and diced into bonds that were bought by just about every financial institution imaginable: investment banks, commercial banks, hedge funds, pension funds. For many of those mortgage-backed securities, credit default swaps were taken out to protect against default. Soon, companies like AIG weren't just insuring houses. They were also insuring the mortgages on those houses by issuing CDS. By the time AIG was bailed out, it held $440 billion USD of these instruments.

BANKS' SECRET MANEUVERS

Banks have a vested interest in keeping the CDS market opaque, because as dealers, they have a high volume of transactions, giving them an edge over other buyers and sellers. Since customers don't know where the market is, the banks charge them much wider profit margins. The idea for the banks is to make a profit on each trade and avoid taking on the swap's risk. As one CDS dealer puts it, "Dealers are just like bookies. Bookies don't want to bet on games. They just want to balance their books. That's why they're called bookies."

In a typical CDS deal, a hedge fund will sell protection to a bank, which will then resell the same protection to another bank, and such dealing will continue, sometimes in a circle, creating a huge concentration of risk. Traders, and banks that serve as dealers, don't always know exactly what is covered by a CDS contract. More than half of all CDSs cover indexes of companies and debt securities, such as asset-backed securities (aka sub-prime mortgages). If the CDS defaults, these guys have already bumped up the stock price, cashed out the stock options and vested shares, collected the yearend bonuses, now it is the investors' problem. Countless billions have been siphoned out of the economic system in this manner by the intermediaries and stashed away in their Swish accounts or spent lavishly in conspicuous consumption mansions, wedding costing millions and private airplanes for pleasure.

According to the U.S. Comptroller of the Currency, at the end of the third quarter of this year, this nation's top 25 banks held more than $13 trillion in credit-default swaps, where they acted as either the insured or the insurer.

TIME BOMB

This volatile situation is exacerbated by the heavy trading volume of the instruments, the secrecy surrounding the trades, and the lack of regulation. An original CDS can go through many trades, and when a default occurs, the insured party doesn't know who's responsible for making up the default and if that end player has the resources to cure the default.

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, or if the "insurer" goes bankrupt (Bear Stearns was almost there, and AIG was almost there) the buyer is not covered - period. The premium payments are gone, as is the insurance against default. In other words, three of the nation's largest financial institutions had made more bad bets than they could afford to pay off. Bear Stearns was sold to J.P. Morgan for pennies on the dollar, Lehman Brothers was allowed to go belly up, and AIG, considered too big to let fail, is on life support to thanks to a $123 billion investment by U.S. taxpayers.

Are you shocked now? Are you wondering what's really going on in the market? The truth is probably more frightening than your worst fears. And yet, you won't hear about it anywhere because the government can't tell you. The U.S. Federal Reserve and the U.S. Treasury Department can't tell you what's really going on because there's nothing they can do about it, except trying to add liquidity.

Nobody knows how federal intervention might ripple through this chain of contracts and the big problem is that here are all these public companies - banks and corporations - and no one really knows what exposure they've got from the CDS contracts.

The Bank for International Settlements recently reported that total derivatives trades exceeded one quadrillion dollars - that's 1,000 trillion dollars -roughly about 17 times the gross domestic product of all the countries in the world combined.

Now as the economy contracts and bankruptcies spread across the world, there's a high probability that many who bought swap protection will wind up in court trying to get their payouts. If things are collapsing left and right, people will do whatever they can and try to collect. And yet all the dealers that handsomely profited from these dirty deals have their money securely hidden away and safe from any financial meltdown.