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Credit Default Swaps: Next Phase of an Unravelling
Crisis
By F. William Engdahl
Global Research, June 5, 2008
The Sub Prime Meltdown is but the Tip of the Iceberg
While attention has been focussed on the relatively tiny US
"sub-prime" home mortgage default crisis as the center of the
current financial and credit crisis impacting the Anglo-Saxon
banking world, a far larger problem is now coming into focus.
Sub-prime or high-risk Collateralized Mortgage Obligations, CMOs as
they are called, are only the tip of a colossal iceberg of dodgy
credits which are beginning to go sour. The next crisis is already
beginning in the $62 TRILLION market for Credit Default Swaps. You
never heard of them? It’s time to take a look, then.
The next phase of the unravelling crisis in the US-centered
"revolution in finance" is emerging in the market for arcane
instruments known as Credit Default Swaps or CDS. Wall Street
bankers always have to have a short name for these things.
As I pointed out in detail in my earlier exclusive series, the
Financial Tsunami, Parts I-V, the Credit Default Swap was invented a
few years ago by a young Cambridge University mathematics graduate,
Blythe Masters, hired by J.P. Morgan Chase Bank in New York. The
then-fresh university graduate convinced her bosses at Morgan Chase
to develop a revolutionary new risk product, the CDS as it soon
became known.
A Credit Default Swap is a credit derivative or 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." CDS’s became
staggeringly popular as credit risks exploded during the last seven
years in the United States. Banks argued that with CDS they could
spread risk around the globe.
Credit default swaps 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 requirement to actually hold any asset
or suffer a loss, credit default swaps can also be used for
speculative purposes.
Warren Buffett once described derivatives bought speculatively as
"financial weapons of mass destruction." In his Berkshire Hathaway
annual report to shareholders he said "Unless derivatives contracts
are collateralized or guaranteed, their ultimate value depends on
the creditworthiness of the counterparties. In the meantime, though,
before a contract is settled, the counterparties record profits and
losses -often huge in amount- in their current earnings statements
without so much as a penny changing hands. The range of derivatives
contracts is limited only by the imagination of man (or sometimes,
so it seems, madmen)." A typical CDO is for five years term.
Like many exotic financial products which are extremely complex and
profitable in times of easy credit, when markets reverse, as has
been the case since August 2007, in addition to spreading risk,
credit derivatives, in this case, also amplify risk considerably.
Now the other shoe is about to drop in the $62 trillion CDS market
due to rising junk bond defaults by US corporations as the recession
deepens. That market has long been a disaster in the making. An
estimated $1,2 trillion could be at risk of the nominal $62 trillion
in CDOs outstanding, making it far larger than the sub-prime market.
No Regulation
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. This so-called counterparty
risk is a ticking time bomb. The US Federal Reserve under the
ultra-permissive chairman, Alan Greenspan and the US Government’s
financial regulators allowed the CDS market to develop entirely
without any supervision. Greenspan repeatedly testified to skeptical
Congressmen that banks are better risk regulators than government
bureaucrats.
The Fed bailout of Bear Stearns on March 17 was motivated, in part,
by a desire to keep the unknown risks of that bank’s Credit Default
Swaps from setting off a global chain reaction that might have
brought the financial system down. The Fed's fear was that because
they didn't adequately monitor counterparty risk in credit-default
swaps, they had no idea what might happen. Thank Alan Greenspan for
that.
Those counterparties include J.P. Morgan Chase, the largest seller
and buyer of CDSs.
The Fed only has supervision to regulated bank CDS exposures, but
not that of investment banks or hedge funds, both of which are
significant CDS issuers. Hedge funds, for instance, are estimated to
have written 31% in CDS protection.
The credit-default-swap market has been mainly untested until now.
The default rate in January 2002, when the swap market was valued at
$1.5 trillion, was 10.7 percent, according to Moody's Investors
Service. But Fitch Ratings reported in July 2007 that 40 percent of
CDS protection sold worldwide was on companies or securities that
are rated below investment grade, up from 8 percent in 2002.
A surge in corporate defaults will now leave swap buyers trying to
collect hundreds of billions of dollars from their counterparties.
This will to complicate the financial crisis, triggering numerous
disputes and lawsuits, as buyers battle sellers over the technical
definition of default - - this requires proving which bond or loan
holders weren't paid -- and the amount of payments due. Some fear
that could in turn freeze up the financial system.
Experts inside the CDS market believe now that the crisis will
likely start with hedge funds that will be unable to pay banks for
contracts tied to at least $150 billion in defaults. Banks will try
to pre-empt this default disaster by demanding hedge funds put up
more collateral for potential losses. That will not work as many of
the funds won't have the cash to meet the banks' demands for more
collateral.
Sellers of protection aren't required by law to set aside reserves
in the CDS market. While banks ask protection sellers to put up some
money when making the trade, there are no industry standards. It
would be the equivalent of a licensed insurance company selling
insurance protection against hurricane damage with no reserves
against potential claims.
Basle BIS worried
The Basle Bank for International Settlements, the supervisory
organization of the world’s major central banks is alarmed at the
dangers. The Joint Forum of the Basel Committee on Banking
Supervision, an international group of banking, insurance and
securities regulators, wrote in April that the trillions of dollars
in swaps traded by hedge funds pose a threat to financial markets
around the world.
``It is difficult to develop a clear picture of which institutions
are the ultimate holders of some of the credit risk transferred,''
the report said. ``It can be difficult even to quantify the amount
of risk that has been transferred.''
Counterparty risk can become complicated in a hurry. 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. That has created a huge
concentration of risk. As one leading derivatives trader expressed
the process, "The risk keeps spinning around and around in this
daisy chain like a vortex. There are only six to 10 dealers who sit
in the middle of all this. I don't think the regulators have the
information that they need to work that out.''
Traders, and even the banks that serve as dealers, don't always know
exactly what is covered by a credit-default-swap contract. There are
numerous types of CDSs, some far more complex than others. More than
half of all CDSs cover indexes of companies and debt securities,
such as asset-backed securities, the Basel committee says. The rest
include coverage of a single company's debt or collateralized debt
obligations...
Banks usually send hedge funds, insurance companies and other
institutional investors e-mails throughout the day with bid and
offer prices, as there is no regulated exchange to pricess the
market or to insure against loss. To find the price of a swap on
Ford Motor Co. debt, for example, even sophisticated investors might
have to search through all of their daily e-mails.
Banks want Secrecy
Banks have a vested interest in keeping the swaps market opaque,
because as dealers, the banks have a high volume of transactions,
giving them an edge over other buyers and sellers. Since customers
don't necessarily know where the market is, you can charge them much
wider profit margins.
Banks try to balance the protection they've sold with credit-default
swaps they purchase from others, either on the same companies or
indexes. They can also create synthetic CDOs, which are packages of
credit-default swaps the banks sell to investors to get themselves
protection.
The idea for the banks is to make a profit on each trade and avoid
taking on the swap's risk. As one CDO dealer puts it, "Dealers are
just like bookies. Bookies don't want to bet on games. Bookies just
want to balance their books. That's why they're called bookies."
Now as the economy contracts and bankruptcies spread across the
United States and beyond, 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 use
any trick they can.
Last year, the Chicago Mercantile Exchange set up a federally
regulated, exchange-based market to trade CDSs. So far, it hasn't
worked. It's been boycotted by banks, which prefer to continue their
trading privately.
Global Research Associate F. William Engdahl is author of A Century
of War: Anglo-American Oil Politics and the New World Order (PlutoPress),
and Seeds of Destruction: The Hidden Agenda of Genetic Manipulation.
(Global Research, available at www.globalresearch.ca). He may be
reached at info@engdahl.oilgeopolitics.net.
