Credit Default Swaps: Financial Weapons of Mass Destruction

CREDIT DEFAULT SWAPS

A credit default swap (CDS) is a credit derivative contract between two counterparties. The buyer makes periodic payments to the seller, and in return receives a payoff if an underlying financial instrument defaults. In effect, the owner of a credit default swap is short the underlying going concern.

Many of the largest Wall Street banks are heavily involved in the derivative markets with reported (.pdf) notional amounts outstanding as of 31 December 2008 for JP Morgan (JPM) at $87.4T, Goldman Sachs (GS) at $30.2T and the single digit midgets of Bank of America (BAC) and Citigroup (C) at $38.3T and $31.9T, respectively.

The Financial Times reported,

As a result, speculation is rife that Morgan might have deliberately provoked the default of BTA to profit on its CDS, since a default makes the US bank a net winner, not a loser as logic might suggest. Morgan Stanley, for its part, refuses to comment on this speculation (although its officials note that the bank does not generally take active “short” positions in its clients). And I personally have no way of knowing whether Morgan is short or long, since Morgan refuses to disclose details of its CDS holding. Right now more than $700 million BTA CDS contracts are registered with the Depositary Trust & Clearing Corp. in New York.

This represents about 12.3% of the total liabilities to credit institutions. But later in the article the key point is hit upon:

But the rub for regulators and investors is that BTA credit risk has not entirely disappeared: Somebody right now is holding the other side of Morgan Stanley’s contracts, and unfortunately there is little way for outsiders to know exactly who. Worse, the presence of those CDS contracts makes it fiendishly hard to work out what the true incentives of any creditors are. In theory, lenders should have an interest in avoiding default. In practice, CDS players do not. The credit world has become a hall of mirrors, where nothing is necessarily as it seems. At best, this makes it very difficult to tell how corporate defaults will affect banks; at worst, it creates the risk of needless value destruction as creditors tip companies into default.

HYPOTHETICAL

For the sake of argument and simplicity assume that Bank G loans Company M $1M in either a leveraged buyout or some other type of deal that was common over the past few years when credit flowed freely. Then Bank G purchases a CDS on Company M’s loan for $30,000 from Bank B and the CDS is reinsured by Insurance Company A.

Company M deteriorates because its free cash flow and a little more all goes to service debt and Bank G sells 90% of its loan to Bank J. Because credit risk has increased Company M’s bond now trades in the market for $25,000 and Bank J purchases a CDS from Bank L for the current market price of $60,000 and reinsured by Insurance Company A. Banks B and L go bankrupt, the trader at Bank L who sold Bank J the CDS now either goes to work at Bank J or receives consulting fees and the privileged creditors of Banks B and L, such as subsidiaries of Bank J and G, receive government bailout payments through Insurance Company A.

Company B, while still able to service its debt, does violate some provision of its debt covenant.

First, being friendly competitors Bank G and J decide to both press for default proceedings and then initiate settlement of the CDS they own.

Second, they fund a SIV with $25,000 of cash which borrows another $825,000 from the Bank’s government puppets.

Third, the SIV pays Banks G and J $850,000 of cash for the Company M loan which, while trading for $25,000 in the market is being carried on their balance sheet for $600,000 and consequently results in a $250,000 gain on the income statement for the quarter after having written down a couple quarters ago.

Fourth, Banks G and J receive $2M in bailout funds for the failed CDS contracts.

Fifth, Company M is completely evaporated and thousands of workers lose their jobs.

Total profit for Banks G and J: $2.85M-$1M-$30k-60k=$1.76M. Nice pay for a day’s work slaughtering and cremating a slight hobbling but otherwise generally healthy going concern.

FINANCIAL WMDs AND FINANCIAL TERRORISTS

As the great credit expansion continued it culminated in hundreds of trillions of dollars worth of derivative instruments. Some of these are registered while many, if not most, are not. These instruments are at the evaporating top of the liquidity pyramid while gold and silver are at the bottom tip.

Just imagine what the GLD ETF Authorized Participants, including Bear Stearns & Co. Inc., Lehman Brothers Inc., Citigroup Global Markets Inc., Merrill Lynch,Goldman Sachs, J.P. Morgan Securities, and Morgan Stanley & Co., will use the language in the prospectus to do.

These derivatives, with their fiendish counter-party risk, infest the balance sheets of almost every publicly traded corporation along with many local, state and national governments. Financial terrorists are greatly incentivized to detonate these financial weapons of mass destruction.

POTENTIAL REMEDIES

When confronted with these type of financial terrorists society has often had to take powerful measures. For example, when John Law co-opted the French economy and tried to prevent its credit contraction by outlawing the use of gold and silver with the death penalty, the French Revolution was sparked.

In the United States of America Section 19 of the Coinage Act of 1792 provided,

That if any of the gold or silver coins which shall be struck or coined at the said mint shall be debased or made worse as to the proportion of fine gold or fine silver therein contained, or shall be of less weight or value than the same ought to be pursuant to the directions of this act, through the default or with the connivance of any of the officers or persons who shall be employed at the said mint, for the purpose of profit or gain, or otherwise with a fraudulent intent, and if any of the said officers or persons shall embezzle any of the metals which shall at any time be committed to their charge for the purpose of being coined, or any of the coins which shall be struck or coined at the said mint, every such officer or person who shall commit any or either of the said offences, shall be deemed guilty of felony, and shall suffer death.

Under Section 9 of that Act a Dollar is

to be of the value of a Spanish milled dollar as the same is now current, and to contain three hundred and seventy one grains and four sixteenth parts of a grain of pure, or four hundred and sixteen grains of standard silver.

While the USA has 303M people about 2.3M are incarcerated or more than 1 in 100 American adults and it officially executed 59. On the other hand, the police state China has about 1.5M incarcerated adults and officially executed 3,400.

While China has had its problems it has not appeared to have had any serious problems with their domestic banks and derivative instruments. Perhaps a reason is because of how they deal with financial crimes. For example, the New York Times reported that Zheng Xiaoyu, former head of the State Food and Drug Administration in China, admitted to taking bribes to approve untested medicine and he was swiftly executed.

CONCLUSION

Because the great credit contraction has begun, capital has started burrowing down the liquidity pyramid to safety and liquidity. Individuals, companies and governments have more leverage than they can sustain.

With the Federal Reserve refusing to comply with Bloomberg’s FOIA request for where trillions of dollars have gone and with JP Morgan, Goldman Sachs, Bank of America and Citigroup all acting like Morgan Stanely and ‘refuse to disclose’ it does beg the questions: What are the next companies to be destroyed? How many hundreds of thousands of jobs will be lost as a result? What will the American people do about it?

 

Original Article