Activity in CDS Market Works in the Fed's Best Interest

Wednesday night the central bankers huddled and decided to inject $240 billion into the worldwide banking system in an attempt to thaw the credit lending freeze—a result of the turmoil engulfing Wall Street and risky banks. This liquidity move addresses any shortage of capital to lend, but not the issue of trust that has been lost. It will then help the commercial credit market so that companies can continue to get affordable short term credit to keep their payrolls paid, but it does not address the central theme of this credit crisis which centers around Credit Default Swap [CDS] derivative contracts.

CDSs were created by Wall Street almost ten years ago. They now total some $60-65 trillion and in aggregate are some multiple, and growing, greater than the combined net worth of the world. There is yet no central clearing house to clear CDSs like there is for stocks, bonds, options, and futures contracts. Instead, dealers clear trades manually and assume the risk of default in all the trades they do. CDSs were infamously considered contracts to off-load risk by former Fed Chairman Greenspan who counseled Congress not to regulate them and to eliminate the Glass Steagal Act which kept a wall between traditional banking and investment banking. Without regulation the market grew 100 fold over the last seven years, according to a Bloomberg News report.

Credit Default Swaps are securities used to speculate on the credit worthiness of a loan. The owner of a CDS gets face value of the contract in exchange for the underlying securities or the cash should a company fail to pay or break a loan covenant. CDSs therefore serve as insurance contracts for the owner of the CDS. Just like option contracts, CDSs became a market unto themselves with dealers taking bets on loan repayments others had made. That is, banks and investment banks bought and sold them to hedge their portfolios and to speculate on the upside and downside event of companies and financial institutions including banks, brokers and insurance companies.

The current market is characterized by enormous number of these contracts being held on the books of financial institutions and because of the housing crisis and slumping economy, credit risk is an amplified concern. Moreover, absent a central clearing house to assume the intermediary risk, dealers have almost altogether stopped trading CDSs—a situation akin to 'Hot Potato' or Russian Roulette. This new illiquidity was a logical eventuality when the credit risk became a heightened concern and gave way to worries about counter-party risk, the risk that the other side or someone who was owed by someone else, who owed you, might be stuck with a Hot Potato CDS such that they could not pay it off, causing a domino effect.

The Federal Reserve and US Treasury have attempted to address the financial systems problems by various ways from cutting interest rates to help banks recapitalize, to opening its discount window and accepting low grade securities for collateral, to arranging 'shotgun marriages' to avert bankruptcy, to making equity loans with taxpayer money to bail out and backstop private firms.

All these market intervention activities have probably helped prevent a global financial system collapse but it has also created both a moral hazard and implicit 'too big to fail' government policy that is arbitrarily applied—Fannie Mae (FNM), Freddie Mac (FRE) and AIG (AIG) were bailed out while Bear Stearns and Lehman (LEH) were left to fail. They used taxpayer money to make decisions based on ad hoc judgments, and not based on fair application of rules, explicit guidelines, or law.

So where are we going in this extraordinary adventure? The latest is that some ominous hedge fund traders are shorting the shares of the remaining Wall Street firms and wounded banks driving down their share prices while buying CDS spreads to force up the cost of debt insurance thereby rendering the target firms vulnerable to takeover or face bankruptcy.

There is a timeless adage that we should consider in times like these: "Follow the Money." Moreover we should ask, who benefits by the final outcome? Seems to SB that one party is that will be the biggest potential benefactor of combining investment banks with commercial banks is the Fed. Underlying the financial crisis is a power grab. Who shall be the supreme regulator? Could it be that the Fed, or some entity acting on their behalf, is using the capital markets to force a fait d'accomplis—banks controlling Wall Street—thereby ending the debate of who's finally in charge? Just a speculation, but well worth an investigation in these unbelievable times. Don't you think?

Psst: That would mean the SEC, Congress, somebody.

Comments

[djsunshine:]

I think political wrengling and vested interest delayed the fix and put us all in to bigger hole. Today's fix was needed one year ago and every one new about it. Feds,Congress and Admin. All these vested interests prevents them to become bold leader. So we have this leadership crisis with world class problem.

2008 Sep 19 09:06 AM

[Nelson_Lai1975:]

Credit Default Swaps, the 62 Trillions Dollars Question. How can anyone (other than Mr. Market ) fix this mess.

Now, the US FED wants to fix it for Mr. Market, how can we profit from it ?

2008 Sep 20 10:43 AM

[jelax:]

What will happen to this and FNM's stock prices during the next quarter with all this intervention?

2008 Sep 22 02:38 PM