The $60 Trillion Nightmare of Credit Default Swaps 26 comments
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The 60 plus trillion dollar nightmare of the CDS (Credit Default Swaps) market is a dangerous anomaly of the tail wagging the dog, pushing risk premium higher against a downward spiral of collapsing market capitalization and lowered credit ratings for corporate debt.
Imagine, 60 plus trillion dollars in total existing liabilities in the unregulated OTC (Over-The-Counter) market of Credit Default Swaps means that our government, in fact, all governments interconnected in the global economy could not possibly “bail out” that entire amount if ever forced to claim. That’s more than the entire world’s GDP combined!
I am very pleased to hear that the Federal Reserve is taking measures to act as a potential counter-party to the commercial paper market that has remained frozen, as institutions are unwilling to lend short-term debt without a reliable bond insurance guarantee in swaps through the OTC market.
The Chicago Mercantile Exchange (CME) is the first major exchange taking initiatives to create a dynamic and transparent market for Credit Default Swaps and, most importantly, a clearing function that adds liquidity and accountability in a regulated forum. But we are up against the clock and in order to truly facilitate liquidity in the tight credit markets, there must be a viable alternative to achieve price discovery in guaranteed bond and debt insurance.
However, since these are unusual times when conventional rules don’t apply, I would like to see the Federal Reserve in combination with the proper regulatory body step in and disqualify all existing Credit Default Swaps in the OTC market. The OTC market is a rabid beast out of control that needs to be put down before the contagion spreads irreversibly.
For those that don’t know, Credit Default Swaps are essentially an insurance contract that company A would use to hedge against loaning money to company B in case the borrower, or Company B, were in default and unable to repay the existing loan.
The intention was good but we all know where that road leads…
The problem was that like any bubble reaching its elliptical peak, the CDS market became absolutely inundated with speculators that were flipping these insurance contracts in a very opaque, highly illiquid and non-transparent unregulated market.
When the economy was thriving, the risk of default was very low against corporate debt and it was an easy and understandably, lucrative business to “sell insurance premium” without undue caution or concern of paying out on the claim. This is the reason that AIG. was bailed out by the Treasury with an $80 plus billion dollar bridge loan. The risk of default was systemic and AIG. was sitting at the heart of this market as the premiere counter-party that sold insurance.
But, the problems were worse as hotshot speculators also jumped in selling these insurance contracts without any accountable requirement to maintain margins or the potential ability to pay these claims. This may be the worst example of free markets gone wild, when the money was free and no one was there to play babysitter and govern unquantifiable liability.
Since the CDS market remains an unregulated OTC market, in my opinion, there should be no reason that it can’t be shut down completely. Just disband the entire racket and have the dirty, smoke filled gambling den closed for business permanently.
This is the opportune moment to commit such drastic action and invalidate a monster liability on the entire global financial system that is dragging the markets down the drain. You could do this by, simultaneously, providing a regulated, transparent Credit Default Swap market on major exchanges like the CME and allow the transition to be as seamless as possible without incurring overwhelming risk to lenders by unhedged loans.
Perhaps, as part of the transition to a regulated swap market on an open exchange, you could stipulate and insist that all open or existing contracts are null and void, that counter-parties remain obligated to redeem the “insurance premium” paid and received only. By mandating some type of enforcement to this unregulated market, you could remove the potential liability from unrecoverable claims that hang like a noose around the neck of the entire economy.
Firms that sold premium or Credit Default Swaps were not even required to put up a substantial margin, less than pennies on the dollar, which means that any firm that bought bond insurance against potential default risk of debtors were basically uninsured if they ever had to make a claim. The entire market was so undercapitalized that it is nothing short of criminal neglect to have allowed this avalanche of default liability to escalate to levels that were reached. This was a scam no different than unscrupulous fly-by-night life insurance companies that sell innocent people a promise without the intention of ever paying a claim.
It’s speculative risk so out of control that it makes a crack addict with a stimulus check look like a savvy investor. This should never have been allowed to get where it has, completely over leveraged and threatening to bring down this house of cards. The spreads are so insane in risk premium that they are pricing solvent corporations to the point of bankruptcy or, even worse, the entire global economy heading into an unrecoverable and sustained depression. The unregulated OTC market of swaps is the smoking gun holding the entire economy hostage to unregulated credit risk exposure.
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This article has 26 comments:
- If AIG & others have that much insurance in force, wouldn't they have to disclose it in their annual financial statemetns? Not saying you're wrong; just questioning the basis & accuracy for the $60 trillion figure you're throwing out. Also, what exactly would trigger coverage? Whose bonds are being covered? If it's Exxon's - not a big risk. Without any details, not very helpful.
Id like to know what percentage of the $60T CDSs out there are naked. These are the ones that are troublesome since they are /were written without owning any security.
My take on the situation is that because the solution to the ‘credit freeze’ is so simple, i.e. “…simultaneously, providing a regulated, transparent Credit Default Swap market on major exchanges like the CME and allow the transition to be as seamless as possible…”, there are very influential ‘counterparties / players’ that don’t want to end that $62 trillion game.
What is needed in this instance are some leaders with sufficient authority and the balls to bust up that illegal racket. I don’t think we have any that in this country. Our leaders require a piece of the action before they’ll do anything.
Look at the 20% rake on the $700 billion bailout bill…now $840 billion. How much is 20% of the $62 trillion CDS Market???? That’s the problem!!!
CZ
Sorry for being stupid, but whats the rake you speak of? Is that the amount the gov't bumped up the package? ?
I'm a day trader, and if you totalled up the sum of all of my trades this year it would be roughly 4 million dollars. But I never had more than about 110 thousand dollars worth of equity. But in the world of high finance I could probably borrow 120 million dollars. A figure 30 times a meaningless number. That's why I call the bulk of CDSs a fantasy.
Why can't an intelligent banker recognize that the insurance he's buying is worthless. That's a question which needs to be asked....over and over.
Was the mortgage game any different--selling mortgages to individuals knowing they could never hope to make good on them, in the long term--you know the $500,000 no-doc/no-income verification deals to people making $45,000/yr.
Meanwhile, I don't understand why they have done anything shut it down up till now?
Now ain't that the truth one of the best lines I read in the article.
Polls, polls, polls, sounds like Trick-or-Treat to me.
Daniel Ivandjiiski
I can't believe all of this nonsense over AIG. IS EVERYONE STUPID! Obama made damaging reckless comments and didn't even look into the issue. The conference was set a year in advance and paid for by the marketing budget of the insurance companies which can not be tapped to pay back the loan from the FED and the FED loan money is not going into the insurance companies budget at all! Plus, the FED now owns AIG, even after AIG pays back the 100 plus billion dollar loan, the FED owns them. Why are we mad about a conference where 100 of their biggest clients were wined and dined by a 10 AIG employees that was paid for by the insurance companies? That is standard practice. The insurance company has a billion dollar marketing budget and needs now more than ever to keep their huge clients. The better AIG does the better tax payers will be when the FED sells the 79 percent interest later. Piling on against AIG is actually against every taxpayers best interest. We want them to thrive not go bankrupt !!!!
Actually ‘rake’ is a misnomer; I should’ve just said fee or commission in addition to the $700 billion. Sorry for the confusion.
‘Rake’ is a term used in reference to the house’s (casino’s) ‘take’ or commission removed from the total ante in various card games.
More specifically, a 20% rake on $700 billion would be $140 billion for the house (pun intended…as in Congress), leaving the winner (the banks, ins. cos., etc…) with $560 billion and me with the, now obvious, misnomer.
if this "casino' is allowed to continue at our expense as taxpaying investors then people need revengee
Your suggestion to declare all contracts outstanding on the OTC null and void is an interesting one. As long as the CDS noose is around our necks, the economy cannot recover. Any bad news relating to a bankruptcy could rupture the system as the CDS effect multiplies the losses on a bankruptcy, leading to further bankruptcies and, ultimately, a complete breakdown of the financial system.
Other than that, it's a beautiful day today.
Seems unfair that the 'true" figure lent or awarded to/for banks is 20% less tha the passed bill/law(s) .... Im beginning to lose track of the number of programs out there and which ones are funded / started ??!!