Credit Default Swaps the next crisis -- subprime is just a �Vorspeise�
By F. William Engdahl
Online Journal Contributing Writer
Jun 10, 2008, 00:18
attention has been focussed on the relatively tiny US "subprime� 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 instruments 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.
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.
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.
Default Swap is a credit derivative or agreement between two counterparties, in
which one makes periodic payments to the other and gets the 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."
CDSes became staggeringly popular as credit risks exploded during the last
seven years in the United States. Banks argued that with CDSes they could
spread risk around the globe.
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.
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 a five-year term.
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.
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
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 JPMorgan Chase, the largest
seller and buyer of CDSes.
The Fed only has supervision of regulated banks' 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 percent 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 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 preempt
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 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.
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."
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
CDSes, some far more complex than others. More than half of all CDSes 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 market prices 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
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
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 CDSes. So far, it hasn't
worked. It's been boycotted by banks, which prefer to continue their trading
� 2008 F. William Engdahl
William Engdahl is author of the book, �A Century of War: Anglo-American
Oil Politics and the New World Order,� Pluto Press Ltd. He has a soon-to-be
published book on GMO titled, �Seeds of Destruction: The Hidden Political
Agenda Behind GMO.� He may be contacted through his website, www.engdahl.oilgeopolitics.net.
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