The Next Crisis: ‘Credit Default Swaps’; Subprime is Just a ‘Vorspeise’

F. William Engdahl / Online Journal | June 15, 2008
While 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.
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 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.
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 a five-year 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 subprime 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 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.
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 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 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 CDSes. So far, it hasn’t
worked. It’s been boycotted by banks, which prefer to continue their
trading privately.
F. 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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