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The worst of the global financial crisis is yet to com
- Thread starter uobboss
- Start date
AIG credit crunch pt1
By Lilla Zuill
NEW YORK (Reuters) - Insurer American International Group Inc, working to stave off rating downgrades and shore up the capital of its holding company, has made an unprecedented approach to the Federal Reserve seeking $40 billion in short-term financing, the New York Times said.
Chief Executive Robert Willumstad reached out to the Fed late on Sunday, according to reports in the Times, the Wall Street Journal and business news channel CNBC.
AIG's scramble to secure a Fed lifeline came late into one of the worst-ever days on Wall Street, with Lehman Bros on the verge of collapse, and Bank of America moving to takeover Merrill Lynch & Co.
The Fed normally oversees monetary policy and supervision of banks, but CNBC said AIG was seeking the funds as a temporary measure and planned to repay the Fed with the proceeds from asset sales.
Rating agencies have threatened to downgrade AIG's ratings by Monday morning, said the New York Times.
AIG officials did not immediately respond to requests for comment.
The company, until recently the world's biggest insurer by market capitalization, has been attempting to hammer out an emergency strategic plan after its shares fell nearly 50 percent last week on fears it faced a liquidity crisis.
AIG has been negotiating with various parties including officials from the New York Insurance Department and private equity firms as it seeks ways to free up capital, raise new capital and protect policyholders.
By Lilla Zuill
NEW YORK (Reuters) - Insurer American International Group Inc, working to stave off rating downgrades and shore up the capital of its holding company, has made an unprecedented approach to the Federal Reserve seeking $40 billion in short-term financing, the New York Times said.
Chief Executive Robert Willumstad reached out to the Fed late on Sunday, according to reports in the Times, the Wall Street Journal and business news channel CNBC.
AIG's scramble to secure a Fed lifeline came late into one of the worst-ever days on Wall Street, with Lehman Bros on the verge of collapse, and Bank of America moving to takeover Merrill Lynch & Co.
The Fed normally oversees monetary policy and supervision of banks, but CNBC said AIG was seeking the funds as a temporary measure and planned to repay the Fed with the proceeds from asset sales.
Rating agencies have threatened to downgrade AIG's ratings by Monday morning, said the New York Times.
AIG officials did not immediately respond to requests for comment.
The company, until recently the world's biggest insurer by market capitalization, has been attempting to hammer out an emergency strategic plan after its shares fell nearly 50 percent last week on fears it faced a liquidity crisis.
AIG has been negotiating with various parties including officials from the New York Insurance Department and private equity firms as it seeks ways to free up capital, raise new capital and protect policyholders.
AIG credit crunch pt2
Regulators including New York Insurance Superintendent Eric Dinallo have been holed up at AIG's New York offices over the past two days trying to hammer out a plan.
"We are working to craft a solution to protect the company and policyholders," said a person from the New York Insurance Department, who asked not to be named.
Former AIG CEO Maurice "Hank" Greenberg, who ran the company for nearly four decades, was not involved in any of the discussions, said his spokesman, Glen Rochkind.
"He repeatedly offered to assist in any way he could," added Rochkind.
CASH CRUNCH
AIG, hit by $18 billion in losses over the past three quarters from guarantees it wrote on mortgage derivatives, has had to act quickly after Standard & Poor's said on Friday it may downgrade AIG's ratings.
Ratings downgrades could force AIG to post up to $14.5 billion more in collateral, according to a regulatory filing last month.
Downgrades could also be detrimental to AIG's insurance business, since some policies carry clauses that nullify a contract in the event of downgrades below a certain level.
Over the weekend, the insurer has been working on a three-part plan involving asset sales, shifting regulated capital from the insurance operations to the holding company, and working with private equity investors, said a person familiar with the negotiations.
Regulators including New York Insurance Superintendent Eric Dinallo have been holed up at AIG's New York offices over the past two days trying to hammer out a plan.
"We are working to craft a solution to protect the company and policyholders," said a person from the New York Insurance Department, who asked not to be named.
Former AIG CEO Maurice "Hank" Greenberg, who ran the company for nearly four decades, was not involved in any of the discussions, said his spokesman, Glen Rochkind.
"He repeatedly offered to assist in any way he could," added Rochkind.
CASH CRUNCH
AIG, hit by $18 billion in losses over the past three quarters from guarantees it wrote on mortgage derivatives, has had to act quickly after Standard & Poor's said on Friday it may downgrade AIG's ratings.
Ratings downgrades could force AIG to post up to $14.5 billion more in collateral, according to a regulatory filing last month.
Downgrades could also be detrimental to AIG's insurance business, since some policies carry clauses that nullify a contract in the event of downgrades below a certain level.
Over the weekend, the insurer has been working on a three-part plan involving asset sales, shifting regulated capital from the insurance operations to the holding company, and working with private equity investors, said a person familiar with the negotiations.
AIG credit crunch pt3
The New York Times said AIG's plans to shift capital had to be put on ice because of the time and complexity involved, and that private equity firms withdrew interest over the company's precarious financial health.
Parties in capital-raising talks with AIG included buyout firms Kohlberg Kravis Roberts & Co and J.C. Flowers & Co, another person familiar with the talks said.
An AIG spokesman earlier confirmed the company was evaluating a wide range of options, including asset sales.
Media reports have said that one of the companies on the block was AIG's highly profitable aircraft leasing arm, but the spokesman declined to confirm this was the case.
In late June, AIG said the unit, International Lease Finance Corp, would remain part of AIG.
AIG was founded in China 89 years ago. In the years since, largely under Greenberg's watch, it grew into one of the world's largest insurers, spanning 130 countries and territories and serving 74 million customers.
Greenberg stepped down in 2005, in the midst of an accounting scandal. His successor, Martin Sullivan, was replaced by Willumstad in June after investors grew disgruntled over its three quarters of losses.
Greenberg owns or controls about 12 percent of AIG's stock, making him the largest shareholder.
(Reporting by Lilla Zuill; Editing by Ted Kerr)
The New York Times said AIG's plans to shift capital had to be put on ice because of the time and complexity involved, and that private equity firms withdrew interest over the company's precarious financial health.
Parties in capital-raising talks with AIG included buyout firms Kohlberg Kravis Roberts & Co and J.C. Flowers & Co, another person familiar with the talks said.
An AIG spokesman earlier confirmed the company was evaluating a wide range of options, including asset sales.
Media reports have said that one of the companies on the block was AIG's highly profitable aircraft leasing arm, but the spokesman declined to confirm this was the case.
In late June, AIG said the unit, International Lease Finance Corp, would remain part of AIG.
AIG was founded in China 89 years ago. In the years since, largely under Greenberg's watch, it grew into one of the world's largest insurers, spanning 130 countries and territories and serving 74 million customers.
Greenberg stepped down in 2005, in the midst of an accounting scandal. His successor, Martin Sullivan, was replaced by Willumstad in June after investors grew disgruntled over its three quarters of losses.
Greenberg owns or controls about 12 percent of AIG's stock, making him the largest shareholder.
(Reporting by Lilla Zuill; Editing by Ted Kerr)
BOA to buy ML for 50B
WASHINGTON/NEW YORK (Reuters) - Bank of America Corp said it agreed to buy Merrill Lynch & Co Inc in an all-stock deal worth $50 billion, snagging the world's largest retail brokerage after one of the worst-ever weekends on Wall Street.
The deal came after tense negotiations over the fate of Lehman Brothers Holdings Inc, which triggered concern that market participants would lose faith in other investment banks. Lehman said early on Monday that it would file for Chapter 11 bankruptcy protection.
"It catapults Bank of America into positions of strength in three businesses where they were weak," said James Ellman, portfolio manager at hedge fund Seacliff Capital.
"Now Bank of America has one of the best and largest retail brokerages in the country, one of the top investment banks in the world, and a large stake in one of the best investment managers in the world," Ellman said.
Bank of America agreed to pay 0.8595 shares of Bank of America common stock for each Merrill Lynch share. The price is 1.8 times stated tangible book value.
The bank is buying about $44 billion of Merrill's common shares, as well as $6 billion of options, convertibles, and restricted stock units.
Bank of America said it expects to achieve $7 billion in pretax expense savings, fully realized by 2012, and expects the deal to be accretive to earnings by 2010. The transaction is expected to close in the first quarter of next year.
The price, which comes to about $29 per share, represents a 70 percent premium to Merrill's share price on Friday, although Merrill's shares were trading at $50 in May and over $90 at the beginning of January 2007.
The deal has been approved by directors of both companies. Three Merrill directors will join the Bank of America board.
Stuck with some of the same toxic debt -- much of it mortgage-related -- that torpedoed Lehman's balance sheet, Merrill has been hit hard by the credit crisis and has written down more than $40 billion over the last year.
Last month, Thain arranged to sell over $30 billion in repackaged debt securities to Dallas-based private equity firm Lone Star Funds for 22 cents on the dollar.
In spite of its exposures to complex debt securities, the bank had seen by some as undervalued, in part because of its massive brokerage business, which analysts have said is worth more than $25 billion. The brokerage is the largest in the world by assets under management and number of brokers.
Merrill also has a stake of about 45 percent in the profitable asset manager BlackRock Inc, worth more than $10 billion.
"It could be a powerful fit," said Rick Meckler, chief investment officer at LibertyView Capital Management in New York, before news of the deal emerged.
DUE DILIGENCE
Still, there are risks for BofA, which had little time to complete due diligence of Merrill's books, a particular concern given the complexity of the company's exposure to mortgage-related securities and other complex debt.
"While we view this clearly as a long-term positive for (Bank of America), the stock will likely not respond accordingly as investors near term will focus on greater systemic risk," Oppenheimer & Co analyst Meredith Whitney said in a report on Sunday.
With the brokerage and the BlackRock shares worth more than $35 billion combined, and Merrill's market capitalization at around $26 billion on Friday, investors had been ascribing a negative value to the investment bank, implying huge potential embedded losses.
But this is not the first time Bank of America has done a quick acquisition. In 2005, the bank bought credit card company MBNA after less than a week of due diligence, with Lewis saying the company was comfortable with the acquisition because it knew the people and business well.
Bank of America under Lewis has in fact become renowned for large acquisitions and it has spent over $100 billion since 2004 buying other companies.
Most recently it acquired troubled mortgage lender Countrywide Financial Corp and -- although many were skeptical about this purchase -- veteran analyst Dick Bove said last week the takeover could prove to be a master stroke by Lewis, since the government takeover of mortgage agencies Fannie Mae and Freddie Mac could fuel business for other lenders.
Bank of America was advised by JC Flowers & Co, Fox-Pitt Kelton Cochran Caronia Waller and Bank of America Securities. It was represented by Wachtell, Lipton, Rosen & Katz. Merrill Lynch was represented by Shearman & Sterling.
WASHINGTON/NEW YORK (Reuters) - Bank of America Corp said it agreed to buy Merrill Lynch & Co Inc in an all-stock deal worth $50 billion, snagging the world's largest retail brokerage after one of the worst-ever weekends on Wall Street.
The deal came after tense negotiations over the fate of Lehman Brothers Holdings Inc, which triggered concern that market participants would lose faith in other investment banks. Lehman said early on Monday that it would file for Chapter 11 bankruptcy protection.
"It catapults Bank of America into positions of strength in three businesses where they were weak," said James Ellman, portfolio manager at hedge fund Seacliff Capital.
"Now Bank of America has one of the best and largest retail brokerages in the country, one of the top investment banks in the world, and a large stake in one of the best investment managers in the world," Ellman said.
Bank of America agreed to pay 0.8595 shares of Bank of America common stock for each Merrill Lynch share. The price is 1.8 times stated tangible book value.
The bank is buying about $44 billion of Merrill's common shares, as well as $6 billion of options, convertibles, and restricted stock units.
Bank of America said it expects to achieve $7 billion in pretax expense savings, fully realized by 2012, and expects the deal to be accretive to earnings by 2010. The transaction is expected to close in the first quarter of next year.
The price, which comes to about $29 per share, represents a 70 percent premium to Merrill's share price on Friday, although Merrill's shares were trading at $50 in May and over $90 at the beginning of January 2007.
The deal has been approved by directors of both companies. Three Merrill directors will join the Bank of America board.
Stuck with some of the same toxic debt -- much of it mortgage-related -- that torpedoed Lehman's balance sheet, Merrill has been hit hard by the credit crisis and has written down more than $40 billion over the last year.
Last month, Thain arranged to sell over $30 billion in repackaged debt securities to Dallas-based private equity firm Lone Star Funds for 22 cents on the dollar.
In spite of its exposures to complex debt securities, the bank had seen by some as undervalued, in part because of its massive brokerage business, which analysts have said is worth more than $25 billion. The brokerage is the largest in the world by assets under management and number of brokers.
Merrill also has a stake of about 45 percent in the profitable asset manager BlackRock Inc, worth more than $10 billion.
"It could be a powerful fit," said Rick Meckler, chief investment officer at LibertyView Capital Management in New York, before news of the deal emerged.
DUE DILIGENCE
Still, there are risks for BofA, which had little time to complete due diligence of Merrill's books, a particular concern given the complexity of the company's exposure to mortgage-related securities and other complex debt.
"While we view this clearly as a long-term positive for (Bank of America), the stock will likely not respond accordingly as investors near term will focus on greater systemic risk," Oppenheimer & Co analyst Meredith Whitney said in a report on Sunday.
With the brokerage and the BlackRock shares worth more than $35 billion combined, and Merrill's market capitalization at around $26 billion on Friday, investors had been ascribing a negative value to the investment bank, implying huge potential embedded losses.
But this is not the first time Bank of America has done a quick acquisition. In 2005, the bank bought credit card company MBNA after less than a week of due diligence, with Lewis saying the company was comfortable with the acquisition because it knew the people and business well.
Bank of America under Lewis has in fact become renowned for large acquisitions and it has spent over $100 billion since 2004 buying other companies.
Most recently it acquired troubled mortgage lender Countrywide Financial Corp and -- although many were skeptical about this purchase -- veteran analyst Dick Bove said last week the takeover could prove to be a master stroke by Lewis, since the government takeover of mortgage agencies Fannie Mae and Freddie Mac could fuel business for other lenders.
Bank of America was advised by JC Flowers & Co, Fox-Pitt Kelton Cochran Caronia Waller and Bank of America Securities. It was represented by Wachtell, Lipton, Rosen & Katz. Merrill Lynch was represented by Shearman & Sterling.
Re: BOA to buy ML for 50B
yes golden era is here!! Better convert all your money into gold bars cos' very soon the world paper money shall become truly paper;worthless and governments around the globe start introducing new type of notes every now and then to shore up confidence in the market place.
Share and expect the worst!
yes golden era is here!! Better convert all your money into gold bars cos' very soon the world paper money shall become truly paper;worthless and governments around the globe start introducing new type of notes every now and then to shore up confidence in the market place.
Share and expect the worst!
Something from Washington Post:
http://www.washingtonpost.com/wp-dy...9/25/AR2008092504531.html?hpid=topnews&sub=AR
And remember what LKY said last August in 2007 about the crisis riding itself out within 2007? Well guess who's completely wrong and out of touch.
http://www.washingtonpost.com/wp-dy...9/25/AR2008092504531.html?hpid=topnews&sub=AR
And remember what LKY said last August in 2007 about the crisis riding itself out within 2007? Well guess who's completely wrong and out of touch.
The $55 trillon Question pt1
The financial crisis has put a spotlight on the obscure world of credit default swaps - which trade in a vast, unregulated market that most people haven't heard of and even fewer understand. Will this be the next disaster?
If Hieronymus Bosch were alive today to paint a triptych called "The Garden of Mortgage Delights," we'd recognize most of the characters in the bacchanalia and its hellish aftermath. Looming largest, of course, would be the Luciferian figures of Greed and Excessive Debt. Scurrying throughout would be the Wall Street bankers who turned these burgeoning debts into exotic securities with tangled structures and soporific acronyms - CDO, MBS, ABS - that concealed the dangers within. Needless to say, we'd see the smooth-tongued emissaries of the credit-rating agencies assuring people that assets of lead could indeed be transformed into investments of gold. Finally, somewhere past the feckless Fannie Mae executives and the dozing politicians, one final figure would lurk in the shadows: a hulking and barely recognizable monster known as Credit Default Swaps.
CDS are no mere artist's fancy. In just over a decade these privately traded derivatives contracts ballooned from nothing into a $54.6 trillion market. CDS are the fastest-growing major type of financial derivatives. More important, they've played a critical role in the unfolding financial crisis. First, by ostensibly providing "insurance" on risky mortgage bonds, they encouraged and enabled reckless behavior during the housing bubble. "If CDS had been taken out of play, companies would've said, 'I can't get this [risk] off my books,'" says Michael Greenberger, a University of Maryland law professor and former director of trading and markets at the Commodity Futures Trading Commission. "If they couldn't keep passing the risk down the line, those guys would've been stopped in their tracks. The ultimate assurance for issuing all this stuff was, 'It's insured.'" Second, terror at the potential for a financial Ebola virus radiating out from a failing institution and infecting dozens or hundreds of other companies - all linked to one another by CDS and other instruments - was a major reason that regulators stepped in to bail out Bear Stearns and buy out AIG, whose calamitous descent itself was triggered by losses on its CDS contracts.
And the fear of a CDS catastrophe still haunts the markets. For starters, nobody knows how federal intervention might ripple through this chain of contracts. And meanwhile, as we'll see, two fundamental aspects of the CDS market - that it is unregulated, and that almost nothing is disclosed publicly - may be about to change. That adds even more uncertainty to the equation. "The big problem is that here are all these public companies - banks and corporations - and no one really knows what exposure they've got from the CDS contracts," says Frank Partnoy, a law professor at the University of San Diego and former Morgan Stanley derivatives salesman who has been writing about the dangers of CDS and their ilk for a decade. "The really scary part is that we don't have a clue." Chris Wolf, a co-manager of Cogo Wolf, a hedge fund of funds, compares them to one of the great mysteries of astrophysics: "This has become essentially the dark matter of the financial universe."
AT FIRST GLANCE, credit default swaps don't look all that scary. A CDS is just a contract: The "buyer" plunks down something that resembles a premium, and the "seller" agrees to make a specific payment if a particular event, such as a bond default, occurs. Used soberly, CDS offer concrete benefits: If you're holding bonds and you're worried that the issuer won't be able to pay, buying CDS should cover your loss. "CDS serve a very useful function of allowing financial markets to efficiently transfer credit risk," argues Sunil Hirani, the CEO of Creditex, one of a handful of marketplaces that trade the contracts.
Because they're contracts rather than securities or insurance, CDS are easy to create: Often deals are done in a one-minute phone conversation or an instant message. Many technical aspects of CDS, such as the typical five-year term, have been standardized by the International Swaps and Derivatives Association (ISDA). That only accelerates the process. You strike your deal, fill out some forms, and you've got yourself a $5 million -or a $100 million - contract.
And as long as someone is willing to take the other side of the proposition, a CDS can cover just about anything, making it the Wall Street equivalent of those notorious Lloyds of London policies covering Liberace's hands and other esoterica. It has even become possible to purchase a CDS that would pay out if the U.S. government defaults. (Trust us when we say that if the government goes under, trying to collect will be the least of your worries.)
You can guess how Wall Street cowboys responded to the opportunity to make deals that (1) can be struck in a minute, (2) require little or no cash upfront, and (3) can cover anything. Yee-haw! You can almost picture Slim Pickens in Dr. Strangelove climbing onto the H-bomb before it's released from the B-52. And indeed, the volume of CDS has exploded with nuclear force, nearly doubling every year since 2001 to reach a recent peak of $62 trillion at the end of 2007, before receding to $54.6 trillion as of June 30, according to ISDA.
Take that gargantuan number with a grain of salt. It refers to the face value of all outstanding contracts. But many players in the market hold offsetting positions. So if, in theory, every entity that owns CDS had to settle its contracts tomorrow and "netted" all its positions against each other, a much smaller amount of money would change hands. But even a tiny fraction of that $54.6 trillion would still be a daunting sum.
The credit freeze and then the Bear disaster explain the drop in outstanding CDS contracts during the first half of the year - and the market has only worsened since. CDS contracts on widely held debt, such as General Motors' (GM, Fortune 500), continue to be actively bought and sold. But traders say almost no new contracts are being written on any but the most liquid debt issues right now, in part because nobody wants to put money at risk and because nobody knows what Washington will do and how that will affect the market. ("There's nothing to do but watch Bernanke on TV," one trader told Fortune during the week when the Fed chairman was going before Congress to push the mortgage bailout.) So, after nearly a decade of exponential growth, the CDS market is poised for its first sustained contraction.
ONE REASON THE MARKET TOOK OFF is that you don't have to own a bond to buy a CDS on it - anyone can place a bet on whether a bond will fail. Indeed the majority of CDS now consists of bets on other people's debt. That's why it's possible for the market to be so big: The $54.6 trillion in CDS contracts completely dwarfs total corporate debt, which the Securities Industry and Financial Markets Association puts at $6.2 trillion, and the $10 trillion it counts in all forms of asset-backed debt. "It's sort of like I think you're a bad driver and you're going to crash your car," says Greenberger, formerly of the CFTC. "So I go to an insurance company and get collision insurance on your car because I think it'll crash and I'll collect on it." That's precisely what the biggest winners in the subprime debacle did. Hedge fund star John Paulson of Paulson & Co., for example, made $15 billion in 2007, largely by using CDS to bet that other investors' subprime mortgage bonds would default.
So what started out as a vehicle for hedging ended up giving investors a cheap, easy way to wager on almost any event in the credit markets. In effect, credit default swaps became the world's largest casino. As Christopher Whalen, a managing director of Institutional Risk Analytics, observes, "To be generous, you could call it an unregulated, uncapitalized insurance market. But really, you would call it a gaming contract."
There is at least one key difference between casino gambling and CDS trading: Gambling has strict government regulation. The federal government has long shied away from any oversight of CDS. The CFTC floated the idea of taking an oversight role in the late '90s, only to find itself opposed by Federal Reserve chairman Alan Greenspan and others. Then, in 2000, Congress, with the support of Greenspan and Treasury Secretary Lawrence Summers, passed a bill prohibiting all federal and most state regulation of CDS and other derivatives. In a press release at the time, co-sponsor Senator Phil Gramm - most recently in the news when he stepped down as John McCain's campaign co-chair this summer after calling people who talk about a recession "whiners" - crowed that the new law "protects financial institutions from over-regulation ... and it guarantees that the United States will maintain its global dominance of financial markets." (The authors of the legislation were so bent on warding off regulation that they had the bill specify that it would "supersede and preempt the application of any state or local law that prohibits gaming ...") Not everyone was as sanguine as Gramm. In 2003 Warren Buffett famously called derivatives "financial weapons of mass destruction."
The financial crisis has put a spotlight on the obscure world of credit default swaps - which trade in a vast, unregulated market that most people haven't heard of and even fewer understand. Will this be the next disaster?
If Hieronymus Bosch were alive today to paint a triptych called "The Garden of Mortgage Delights," we'd recognize most of the characters in the bacchanalia and its hellish aftermath. Looming largest, of course, would be the Luciferian figures of Greed and Excessive Debt. Scurrying throughout would be the Wall Street bankers who turned these burgeoning debts into exotic securities with tangled structures and soporific acronyms - CDO, MBS, ABS - that concealed the dangers within. Needless to say, we'd see the smooth-tongued emissaries of the credit-rating agencies assuring people that assets of lead could indeed be transformed into investments of gold. Finally, somewhere past the feckless Fannie Mae executives and the dozing politicians, one final figure would lurk in the shadows: a hulking and barely recognizable monster known as Credit Default Swaps.
CDS are no mere artist's fancy. In just over a decade these privately traded derivatives contracts ballooned from nothing into a $54.6 trillion market. CDS are the fastest-growing major type of financial derivatives. More important, they've played a critical role in the unfolding financial crisis. First, by ostensibly providing "insurance" on risky mortgage bonds, they encouraged and enabled reckless behavior during the housing bubble. "If CDS had been taken out of play, companies would've said, 'I can't get this [risk] off my books,'" says Michael Greenberger, a University of Maryland law professor and former director of trading and markets at the Commodity Futures Trading Commission. "If they couldn't keep passing the risk down the line, those guys would've been stopped in their tracks. The ultimate assurance for issuing all this stuff was, 'It's insured.'" Second, terror at the potential for a financial Ebola virus radiating out from a failing institution and infecting dozens or hundreds of other companies - all linked to one another by CDS and other instruments - was a major reason that regulators stepped in to bail out Bear Stearns and buy out AIG, whose calamitous descent itself was triggered by losses on its CDS contracts.
And the fear of a CDS catastrophe still haunts the markets. For starters, nobody knows how federal intervention might ripple through this chain of contracts. And meanwhile, as we'll see, two fundamental aspects of the CDS market - that it is unregulated, and that almost nothing is disclosed publicly - may be about to change. That adds even more uncertainty to the equation. "The big problem is that here are all these public companies - banks and corporations - and no one really knows what exposure they've got from the CDS contracts," says Frank Partnoy, a law professor at the University of San Diego and former Morgan Stanley derivatives salesman who has been writing about the dangers of CDS and their ilk for a decade. "The really scary part is that we don't have a clue." Chris Wolf, a co-manager of Cogo Wolf, a hedge fund of funds, compares them to one of the great mysteries of astrophysics: "This has become essentially the dark matter of the financial universe."
AT FIRST GLANCE, credit default swaps don't look all that scary. A CDS is just a contract: The "buyer" plunks down something that resembles a premium, and the "seller" agrees to make a specific payment if a particular event, such as a bond default, occurs. Used soberly, CDS offer concrete benefits: If you're holding bonds and you're worried that the issuer won't be able to pay, buying CDS should cover your loss. "CDS serve a very useful function of allowing financial markets to efficiently transfer credit risk," argues Sunil Hirani, the CEO of Creditex, one of a handful of marketplaces that trade the contracts.
Because they're contracts rather than securities or insurance, CDS are easy to create: Often deals are done in a one-minute phone conversation or an instant message. Many technical aspects of CDS, such as the typical five-year term, have been standardized by the International Swaps and Derivatives Association (ISDA). That only accelerates the process. You strike your deal, fill out some forms, and you've got yourself a $5 million -or a $100 million - contract.
And as long as someone is willing to take the other side of the proposition, a CDS can cover just about anything, making it the Wall Street equivalent of those notorious Lloyds of London policies covering Liberace's hands and other esoterica. It has even become possible to purchase a CDS that would pay out if the U.S. government defaults. (Trust us when we say that if the government goes under, trying to collect will be the least of your worries.)
You can guess how Wall Street cowboys responded to the opportunity to make deals that (1) can be struck in a minute, (2) require little or no cash upfront, and (3) can cover anything. Yee-haw! You can almost picture Slim Pickens in Dr. Strangelove climbing onto the H-bomb before it's released from the B-52. And indeed, the volume of CDS has exploded with nuclear force, nearly doubling every year since 2001 to reach a recent peak of $62 trillion at the end of 2007, before receding to $54.6 trillion as of June 30, according to ISDA.
Take that gargantuan number with a grain of salt. It refers to the face value of all outstanding contracts. But many players in the market hold offsetting positions. So if, in theory, every entity that owns CDS had to settle its contracts tomorrow and "netted" all its positions against each other, a much smaller amount of money would change hands. But even a tiny fraction of that $54.6 trillion would still be a daunting sum.
The credit freeze and then the Bear disaster explain the drop in outstanding CDS contracts during the first half of the year - and the market has only worsened since. CDS contracts on widely held debt, such as General Motors' (GM, Fortune 500), continue to be actively bought and sold. But traders say almost no new contracts are being written on any but the most liquid debt issues right now, in part because nobody wants to put money at risk and because nobody knows what Washington will do and how that will affect the market. ("There's nothing to do but watch Bernanke on TV," one trader told Fortune during the week when the Fed chairman was going before Congress to push the mortgage bailout.) So, after nearly a decade of exponential growth, the CDS market is poised for its first sustained contraction.
ONE REASON THE MARKET TOOK OFF is that you don't have to own a bond to buy a CDS on it - anyone can place a bet on whether a bond will fail. Indeed the majority of CDS now consists of bets on other people's debt. That's why it's possible for the market to be so big: The $54.6 trillion in CDS contracts completely dwarfs total corporate debt, which the Securities Industry and Financial Markets Association puts at $6.2 trillion, and the $10 trillion it counts in all forms of asset-backed debt. "It's sort of like I think you're a bad driver and you're going to crash your car," says Greenberger, formerly of the CFTC. "So I go to an insurance company and get collision insurance on your car because I think it'll crash and I'll collect on it." That's precisely what the biggest winners in the subprime debacle did. Hedge fund star John Paulson of Paulson & Co., for example, made $15 billion in 2007, largely by using CDS to bet that other investors' subprime mortgage bonds would default.
So what started out as a vehicle for hedging ended up giving investors a cheap, easy way to wager on almost any event in the credit markets. In effect, credit default swaps became the world's largest casino. As Christopher Whalen, a managing director of Institutional Risk Analytics, observes, "To be generous, you could call it an unregulated, uncapitalized insurance market. But really, you would call it a gaming contract."
There is at least one key difference between casino gambling and CDS trading: Gambling has strict government regulation. The federal government has long shied away from any oversight of CDS. The CFTC floated the idea of taking an oversight role in the late '90s, only to find itself opposed by Federal Reserve chairman Alan Greenspan and others. Then, in 2000, Congress, with the support of Greenspan and Treasury Secretary Lawrence Summers, passed a bill prohibiting all federal and most state regulation of CDS and other derivatives. In a press release at the time, co-sponsor Senator Phil Gramm - most recently in the news when he stepped down as John McCain's campaign co-chair this summer after calling people who talk about a recession "whiners" - crowed that the new law "protects financial institutions from over-regulation ... and it guarantees that the United States will maintain its global dominance of financial markets." (The authors of the legislation were so bent on warding off regulation that they had the bill specify that it would "supersede and preempt the application of any state or local law that prohibits gaming ...") Not everyone was as sanguine as Gramm. In 2003 Warren Buffett famously called derivatives "financial weapons of mass destruction."
The $55 trillon Question pt2
THERE'S ANOTHER BIG difference between trading CDS and casino gambling. When you put $10 on black 22, you're pretty sure the casino will pay off if you win. The CDS market offers no such assurance. One reason the market grew so quickly was that hedge funds poured in, sensing easy money. And not just big, well-established hedge funds but a lot of upstarts. So in some cases, giant financial institutions were counting on collecting money from institutions only slightly more solvent than your average minimart. The danger, of course, is that if a hedge fund suddenly has to pay off on a lot of CDS, it will simply go out of business. "People have been insuring risks that they can't insure," says Peter Schiff, the president of Euro Pacific Capital and author of Crash Proof, which predicted doom for Fannie and Freddie, among other things. "Let's say you're writing fire insurance policies, and every time you get the [premium], you spend it. You just assume that no houses are going to burn down. And all of a sudden there's a huge fire and they all burn down. What do you do? You just close up shop."
This is not an academic concern. Wachovia and Citigroup are wrangling in court with a $50 million hedge fund located in the Channel Islands. The reason: A dispute over two $10 million credit default swaps covering some CDOs. The specifics of the spat aren't important. What's most revealing is that these massive banks put their faith in a Lilliputian fund (in an inaccessible jurisdiction) that was risking 40% of its capital for just two CDS. Can anyone imagine that Citi would, say, insure its headquarters building with a thinly capitalized, unregulated, offshore entity?
That's one element of what's known as "counterparty risk." Here's another: In many cases, you don't even know who has the other side of your bet. Parties to the contract can, and do, transfer their side of the contract to third parties. Investment firms assert that transfers are well documented (a claim that, like most in the world of CDS, is impossible to verify). But even if that's true, you're still left with the fact that a given company's risks are being dispersed in ways that they may not know about and can't control.
It doesn't help that CDS trading is a haphazard process. Most contracts are bought and sold over the phone or by instant message and settled manually. Settlement has been sloppy, confirms Jamie Cawley of IDX Capital, a firm that brokers trades between big banks. Pushed by New York Fed president Timothy Geithner, the players have been improving the process. But even as recently as a year ago, Cawley says, so many trades were sitting around unfulfilled that "there were $1 trillion worth of swaps that were unsettled among counterparties."
Trade settlement is not the only anachronistic aspect of CDS trading. Consider what will happen with CDS contracts relating to Fannie Mae and Freddie Mac. The two were placed in conservatorship on Sept. 7. But the value of many contracts won't be determined till Oct. 6, when an auction will set a cash price for Fannie and Freddie bonds. We'll spare you the technical reasons, but suffice it to ask: Can you imagine any other major market that would need a month to resolve something like this?
WITH WASHINGTON SUDDENLY in a frenzy of outrage over the financial markets, debating everything from the shape and extent of the mortgage plan to what should be done about short-selling, the future for CDS is very blurry. "The market is here to stay," asserts Cawley. The question is simply: What sorts of changes are in store? As this article was going to press, SEC chairman Christopher Cox asked the Senate to allow his agency to begin regulating CDS - mostly, it should be said, to rein in short-selling. And the SEC separately announced that it was expanding its investigation of market manipulation, which initially targeted the short-sellers, to CDS investors.
Under other circumstances, Cox's request might have been met with polite silence. But the convulsions over the mortgage bailout are so dramatic that they are reminiscent of the moment, soon after the Enron scandal, when Congress drafted the Sarbanes-Oxley legislation. The desire to blame short-sellers may actually result in powers for Cox that, until very recently, he showed no signs of wanting. Should legislators wade into this issue, the measures most widely seen as necessary are straightforward: some form of centralized trading or clearing and some form of capital or reserve requirements. Meanwhile, New York State's insurance commissioner, Eric Dinallo, announced new regulations that would essentially treat sellers of some (but not all) CDS as insurance entities, thereby forcing them to set aside reserves and otherwise follow state insurance law - requirements that would probably drive many participants from the market. Whether CDS players will find a way to challenge the rules remains to be seen. (ISDA, the industry's trade group, has already gone on record in opposition to Cox's proposal.) If nothing else, the New York law may provide additional impetus for the feds to take action.
For now, the biggest impact could come from the Financial Accounting Standards Board. It is implementing a new rule in November that will require sellers of CDS and other credit derivatives to report detailed information, including their maximum payouts and reasons for entering the contracts, as well as assets that might allow them to offset any payouts. Anybody who has tried to parse CEO compensation in recent years knows that more disclosure doesn't guarantee clarity, but any increase in information in the CDS realm will be a benefit. Perhaps that would limit the baleful effect of CDS on (must we consider it?) the next disaster - or even help us prevent it.
http://money.cnn.com/2008/09/29/magazines/fortune/varchaver_derivatives.fortune/index.htm
THERE'S ANOTHER BIG difference between trading CDS and casino gambling. When you put $10 on black 22, you're pretty sure the casino will pay off if you win. The CDS market offers no such assurance. One reason the market grew so quickly was that hedge funds poured in, sensing easy money. And not just big, well-established hedge funds but a lot of upstarts. So in some cases, giant financial institutions were counting on collecting money from institutions only slightly more solvent than your average minimart. The danger, of course, is that if a hedge fund suddenly has to pay off on a lot of CDS, it will simply go out of business. "People have been insuring risks that they can't insure," says Peter Schiff, the president of Euro Pacific Capital and author of Crash Proof, which predicted doom for Fannie and Freddie, among other things. "Let's say you're writing fire insurance policies, and every time you get the [premium], you spend it. You just assume that no houses are going to burn down. And all of a sudden there's a huge fire and they all burn down. What do you do? You just close up shop."
This is not an academic concern. Wachovia and Citigroup are wrangling in court with a $50 million hedge fund located in the Channel Islands. The reason: A dispute over two $10 million credit default swaps covering some CDOs. The specifics of the spat aren't important. What's most revealing is that these massive banks put their faith in a Lilliputian fund (in an inaccessible jurisdiction) that was risking 40% of its capital for just two CDS. Can anyone imagine that Citi would, say, insure its headquarters building with a thinly capitalized, unregulated, offshore entity?
That's one element of what's known as "counterparty risk." Here's another: In many cases, you don't even know who has the other side of your bet. Parties to the contract can, and do, transfer their side of the contract to third parties. Investment firms assert that transfers are well documented (a claim that, like most in the world of CDS, is impossible to verify). But even if that's true, you're still left with the fact that a given company's risks are being dispersed in ways that they may not know about and can't control.
It doesn't help that CDS trading is a haphazard process. Most contracts are bought and sold over the phone or by instant message and settled manually. Settlement has been sloppy, confirms Jamie Cawley of IDX Capital, a firm that brokers trades between big banks. Pushed by New York Fed president Timothy Geithner, the players have been improving the process. But even as recently as a year ago, Cawley says, so many trades were sitting around unfulfilled that "there were $1 trillion worth of swaps that were unsettled among counterparties."
Trade settlement is not the only anachronistic aspect of CDS trading. Consider what will happen with CDS contracts relating to Fannie Mae and Freddie Mac. The two were placed in conservatorship on Sept. 7. But the value of many contracts won't be determined till Oct. 6, when an auction will set a cash price for Fannie and Freddie bonds. We'll spare you the technical reasons, but suffice it to ask: Can you imagine any other major market that would need a month to resolve something like this?
WITH WASHINGTON SUDDENLY in a frenzy of outrage over the financial markets, debating everything from the shape and extent of the mortgage plan to what should be done about short-selling, the future for CDS is very blurry. "The market is here to stay," asserts Cawley. The question is simply: What sorts of changes are in store? As this article was going to press, SEC chairman Christopher Cox asked the Senate to allow his agency to begin regulating CDS - mostly, it should be said, to rein in short-selling. And the SEC separately announced that it was expanding its investigation of market manipulation, which initially targeted the short-sellers, to CDS investors.
Under other circumstances, Cox's request might have been met with polite silence. But the convulsions over the mortgage bailout are so dramatic that they are reminiscent of the moment, soon after the Enron scandal, when Congress drafted the Sarbanes-Oxley legislation. The desire to blame short-sellers may actually result in powers for Cox that, until very recently, he showed no signs of wanting. Should legislators wade into this issue, the measures most widely seen as necessary are straightforward: some form of centralized trading or clearing and some form of capital or reserve requirements. Meanwhile, New York State's insurance commissioner, Eric Dinallo, announced new regulations that would essentially treat sellers of some (but not all) CDS as insurance entities, thereby forcing them to set aside reserves and otherwise follow state insurance law - requirements that would probably drive many participants from the market. Whether CDS players will find a way to challenge the rules remains to be seen. (ISDA, the industry's trade group, has already gone on record in opposition to Cox's proposal.) If nothing else, the New York law may provide additional impetus for the feds to take action.
For now, the biggest impact could come from the Financial Accounting Standards Board. It is implementing a new rule in November that will require sellers of CDS and other credit derivatives to report detailed information, including their maximum payouts and reasons for entering the contracts, as well as assets that might allow them to offset any payouts. Anybody who has tried to parse CEO compensation in recent years knows that more disclosure doesn't guarantee clarity, but any increase in information in the CDS realm will be a benefit. Perhaps that would limit the baleful effect of CDS on (must we consider it?) the next disaster - or even help us prevent it.
http://money.cnn.com/2008/09/29/magazines/fortune/varchaver_derivatives.fortune/index.htm
The Monster That Ate Wall Street
They're called "Off-Site Weekends"—rituals of the high-finance world in which teams of bankers gather someplace sunny to blow off steam and celebrate their successes as Masters of the Universe. Think yacht parties, bikini models, $1,000 bottles of Cristal. One 1994 trip by a group of JPMorgan bankers to the tony Boca Raton Resort & Club in Florida has become the stuff of Wall Street legend—though not for the raucous partying (although there was plenty of that, too). Holed up for most of the weekend in a conference room at the pink, Spanish-style resort, the JPMorgan bankers were trying to get their heads around a question as old as banking itself: how do you mitigate your risk when you loan money to someone? By the mid-'90s, JPMorgan's books were loaded with tens of billions of dollars in loans to corporations and foreign governments, and by federal law it had to keep huge amounts of capital in reserve in case any of them went bad. But what if JPMorgan could create a device that would protect it if those loans defaulted, and free up that capital?
What the bankers hit on was a sort of insurance policy: a third party would assume the risk of the debt going sour, and in exchange would receive regular payments from the bank, similar to insurance premiums. JPMorgan would then get to remove the risk from its books and free up the reserves. The scheme was called a "credit default swap," and it was a twist on something bankers had been doing for a while to hedge against fluctuations in interest rates and commodity prices. While the concept had been floating around the markets for a couple of years, JPMorgan was the first bank to make a big bet on credit default swaps. It built up a "swaps" desk in the mid-'90s and hired young math and science grads from schools like MIT and Cambridge to create a market for the complex instruments. Within a few years, the credit default swap (CDS) became the hot financial instrument, the safest way to parse out risk while maintaining a steady return. "I've known people who worked on the Manhattan Project," says Mark Brickell, who at the time was a 40-year-old managing director at JPMorgan. "And for those of us on that trip, there was the same kind of feeling of being present at the creation of something incredibly important."
Like Robert Oppenheimer and his team of nuclear physicists in the 1940s, Brickell and his JPMorgan colleagues didn't realize they were creating a monster. Today, the economy is teetering and Wall Street is in ruins, thanks in no small part to the beast they unleashed 14 years ago. The country's biggest insurance company, AIG, had to be bailed out by American taxpayers after it defaulted on $14 billion worth of credit default swaps it had made to investment banks, insurance companies and scores of other entities. So much of what's gone wrong with the financial system in the past year can be traced back to credit default swaps, which ballooned into a $62 trillion market before ratcheting down to $55 trillion last week—nearly four times the value of all stocks traded on the New York Stock Exchange. There's a reason Warren Buffett called these instruments "financial weapons of mass destruction." Since credit default swaps are privately negotiated contracts between two parties and aren't regulated by the government, there's no central reporting mechanism to determine their value. That has clouded up the markets with billions of dollars' worth of opaque "dark matter," as some economists like to say. Like rogue nukes, they've proliferated around the world and now lie hiding, waiting to blow up the balance sheets of countless other financial institutions.
It didn't start out that way. One of the earliest CDS deals came out of JPMorgan in December 1997, when the firm put into place the idea hatched in Boca Raton. It essentially took 300 different loans, totaling $9.7 billion, that had been made to a variety of big companies like Ford, Wal-Mart and IBM, and cut them up into pieces known as "tranches" (that's French for "slices"). The bank then identified the riskiest 10 percent tranche and sold it to investors in what was called the Broad Index Securitized Trust Offering, or Bistro for short. The Bistro was put together by Terri Duhon, at the time a 25-year-old MIT graduate working on JPMorgan's credit swaps desk in New York—a division that would eventually earn the name the Morgan Mafia for the number of former members who went on to senior positions at global banks and hedge funds. "We made it possible for banks to get their credit risk off their books and into nonfinancial institutions like insurance companies and pension funds," says Duhon, who now heads her own derivatives consulting business in London.
Before long, credit default swaps were being used to encourage investors to buy into risky emerging markets such as Latin America and Russia by insuring the debt of developing countries. Later, after corporate blowouts like Enron and WorldCom, it became clear there was a big need for protection against company implosions, and credit default swaps proved just the tool. By then, the CDS market was more than doubling every year, surpassing $100 billion in 2000 and totaling $6.4 trillion by 2004.
And then came the housing boom. As the Federal Reserve cut interest rates and Americans started buying homes in record numbers, mortgage-backed securities became the hot new investment. Mortgages were pooled together, and sliced and diced into bonds that were bought by just about every financial institution imaginable: investment banks, commercial banks, hedge funds, pension funds. For many of those mortgage-backed securities, credit default swaps were taken out to protect against default. "These structures were such a great deal, everyone and their dog decided to jump in, which led to massive growth in the CDS market," says Rohan Douglas, who ran Salomon Brothers and Citigroup's global credit swaps division through the 1990s.
Soon, companies like AIG weren't just insuring houses. They were also insuring the mortgages on those houses by issuing credit default swaps. By the time AIG was bailed out, it held $440 billion of credit default swaps. AIG's fatal flaw appears to have been applying traditional insurance methods to the CDS market. There is no correlation between traditional insurance events; if your neighbor gets into a car wreck, it doesn't necessarily increase your risk of getting into one. But with bonds, it's a different story: when one defaults, it starts a chain reaction that increases the risk of others going bust. Investors get skittish, worrying that the issues plaguing one big player will affect another. So they start to bail, the markets freak out and lenders pull back credit.
The problem was exacerbated by the fact that so many institutions were tethered to one another through these deals. For example, Lehman Brothers had itself made more than $700 billion worth of swaps, and many of them were backed by AIG. And when mortgage-backed securities started going bad, AIG had to make good on billions of dollars of credit default swaps. Soon it became clear it wasn't going to be able to cover its losses. And since AIG's stock was one of the components of the Dow Jones industrial average, the plunge in its share price pulled down the entire average, contributing to the panic.
The reason the federal government stepped in and bailed out AIG was that the insurer was something of a last backstop in the CDS market. While banks and hedge funds were playing both sides of the CDS business—buying and trading them and thus offsetting whatever losses they took—AIG was simply providing the swaps and holding onto them. Had it been allowed to default, everyone who'd bought a CDS contract from the company would have suffered huge losses in the value of the insurance contracts they hadpurchased, causing them their own credit problems.
Given the CDSs' role in this mess, it's likely that the federal government will start regulating them; New York state has already said it will begin doing so in January. "Sadly, they've been vilified," says Duhon, who helped get the whole thing started with that Bistro deal a decade ago. "It's like saying it's the gun's fault when someone gets shot." But just as one might want to regulate street sales of AK-47s, there's an argument to be made that credit default swaps can be dangerous in the wrong hands. "It made it a lot easier for some people to get into trouble," says Darrell Duffie, an economist at Stanford. Although he believes credit default swaps have been "dramatically misused," Duffie says he still believes they're a very effective tool and shouldn't be done away with entirely. Besides, he says, "if you outlaw them, then the financial engineers will just come up with something else that gets around the regulation." As Wall Street and Washington wring their hands over how to prevent future financial crises, we can only hope they re-read Mary Shelley's "Frankenstein."
http://www.newsweek.com/id/161199
They're called "Off-Site Weekends"—rituals of the high-finance world in which teams of bankers gather someplace sunny to blow off steam and celebrate their successes as Masters of the Universe. Think yacht parties, bikini models, $1,000 bottles of Cristal. One 1994 trip by a group of JPMorgan bankers to the tony Boca Raton Resort & Club in Florida has become the stuff of Wall Street legend—though not for the raucous partying (although there was plenty of that, too). Holed up for most of the weekend in a conference room at the pink, Spanish-style resort, the JPMorgan bankers were trying to get their heads around a question as old as banking itself: how do you mitigate your risk when you loan money to someone? By the mid-'90s, JPMorgan's books were loaded with tens of billions of dollars in loans to corporations and foreign governments, and by federal law it had to keep huge amounts of capital in reserve in case any of them went bad. But what if JPMorgan could create a device that would protect it if those loans defaulted, and free up that capital?
What the bankers hit on was a sort of insurance policy: a third party would assume the risk of the debt going sour, and in exchange would receive regular payments from the bank, similar to insurance premiums. JPMorgan would then get to remove the risk from its books and free up the reserves. The scheme was called a "credit default swap," and it was a twist on something bankers had been doing for a while to hedge against fluctuations in interest rates and commodity prices. While the concept had been floating around the markets for a couple of years, JPMorgan was the first bank to make a big bet on credit default swaps. It built up a "swaps" desk in the mid-'90s and hired young math and science grads from schools like MIT and Cambridge to create a market for the complex instruments. Within a few years, the credit default swap (CDS) became the hot financial instrument, the safest way to parse out risk while maintaining a steady return. "I've known people who worked on the Manhattan Project," says Mark Brickell, who at the time was a 40-year-old managing director at JPMorgan. "And for those of us on that trip, there was the same kind of feeling of being present at the creation of something incredibly important."
Like Robert Oppenheimer and his team of nuclear physicists in the 1940s, Brickell and his JPMorgan colleagues didn't realize they were creating a monster. Today, the economy is teetering and Wall Street is in ruins, thanks in no small part to the beast they unleashed 14 years ago. The country's biggest insurance company, AIG, had to be bailed out by American taxpayers after it defaulted on $14 billion worth of credit default swaps it had made to investment banks, insurance companies and scores of other entities. So much of what's gone wrong with the financial system in the past year can be traced back to credit default swaps, which ballooned into a $62 trillion market before ratcheting down to $55 trillion last week—nearly four times the value of all stocks traded on the New York Stock Exchange. There's a reason Warren Buffett called these instruments "financial weapons of mass destruction." Since credit default swaps are privately negotiated contracts between two parties and aren't regulated by the government, there's no central reporting mechanism to determine their value. That has clouded up the markets with billions of dollars' worth of opaque "dark matter," as some economists like to say. Like rogue nukes, they've proliferated around the world and now lie hiding, waiting to blow up the balance sheets of countless other financial institutions.
It didn't start out that way. One of the earliest CDS deals came out of JPMorgan in December 1997, when the firm put into place the idea hatched in Boca Raton. It essentially took 300 different loans, totaling $9.7 billion, that had been made to a variety of big companies like Ford, Wal-Mart and IBM, and cut them up into pieces known as "tranches" (that's French for "slices"). The bank then identified the riskiest 10 percent tranche and sold it to investors in what was called the Broad Index Securitized Trust Offering, or Bistro for short. The Bistro was put together by Terri Duhon, at the time a 25-year-old MIT graduate working on JPMorgan's credit swaps desk in New York—a division that would eventually earn the name the Morgan Mafia for the number of former members who went on to senior positions at global banks and hedge funds. "We made it possible for banks to get their credit risk off their books and into nonfinancial institutions like insurance companies and pension funds," says Duhon, who now heads her own derivatives consulting business in London.
Before long, credit default swaps were being used to encourage investors to buy into risky emerging markets such as Latin America and Russia by insuring the debt of developing countries. Later, after corporate blowouts like Enron and WorldCom, it became clear there was a big need for protection against company implosions, and credit default swaps proved just the tool. By then, the CDS market was more than doubling every year, surpassing $100 billion in 2000 and totaling $6.4 trillion by 2004.
And then came the housing boom. As the Federal Reserve cut interest rates and Americans started buying homes in record numbers, mortgage-backed securities became the hot new investment. Mortgages were pooled together, and sliced and diced into bonds that were bought by just about every financial institution imaginable: investment banks, commercial banks, hedge funds, pension funds. For many of those mortgage-backed securities, credit default swaps were taken out to protect against default. "These structures were such a great deal, everyone and their dog decided to jump in, which led to massive growth in the CDS market," says Rohan Douglas, who ran Salomon Brothers and Citigroup's global credit swaps division through the 1990s.
Soon, companies like AIG weren't just insuring houses. They were also insuring the mortgages on those houses by issuing credit default swaps. By the time AIG was bailed out, it held $440 billion of credit default swaps. AIG's fatal flaw appears to have been applying traditional insurance methods to the CDS market. There is no correlation between traditional insurance events; if your neighbor gets into a car wreck, it doesn't necessarily increase your risk of getting into one. But with bonds, it's a different story: when one defaults, it starts a chain reaction that increases the risk of others going bust. Investors get skittish, worrying that the issues plaguing one big player will affect another. So they start to bail, the markets freak out and lenders pull back credit.
The problem was exacerbated by the fact that so many institutions were tethered to one another through these deals. For example, Lehman Brothers had itself made more than $700 billion worth of swaps, and many of them were backed by AIG. And when mortgage-backed securities started going bad, AIG had to make good on billions of dollars of credit default swaps. Soon it became clear it wasn't going to be able to cover its losses. And since AIG's stock was one of the components of the Dow Jones industrial average, the plunge in its share price pulled down the entire average, contributing to the panic.
The reason the federal government stepped in and bailed out AIG was that the insurer was something of a last backstop in the CDS market. While banks and hedge funds were playing both sides of the CDS business—buying and trading them and thus offsetting whatever losses they took—AIG was simply providing the swaps and holding onto them. Had it been allowed to default, everyone who'd bought a CDS contract from the company would have suffered huge losses in the value of the insurance contracts they hadpurchased, causing them their own credit problems.
Given the CDSs' role in this mess, it's likely that the federal government will start regulating them; New York state has already said it will begin doing so in January. "Sadly, they've been vilified," says Duhon, who helped get the whole thing started with that Bistro deal a decade ago. "It's like saying it's the gun's fault when someone gets shot." But just as one might want to regulate street sales of AK-47s, there's an argument to be made that credit default swaps can be dangerous in the wrong hands. "It made it a lot easier for some people to get into trouble," says Darrell Duffie, an economist at Stanford. Although he believes credit default swaps have been "dramatically misused," Duffie says he still believes they're a very effective tool and shouldn't be done away with entirely. Besides, he says, "if you outlaw them, then the financial engineers will just come up with something else that gets around the regulation." As Wall Street and Washington wring their hands over how to prevent future financial crises, we can only hope they re-read Mary Shelley's "Frankenstein."
http://www.newsweek.com/id/161199
The economy's 3 vicious cycles
The economy's 3 vicious cycles
The financial crisis consists of three related cycles spinning downward. Be careful trying to stop them.
The global financial tumult is so broad and deep that it's almost too big to grasp, so here's a way to think about it. Every financial crisis involves at least one vicious circle, a process in which things getting bad causes things to get worse.
Today's crisis consists of at least three big vicious circles all of which are meant to be checked by the government's proposed megafix. As we try to sort out each day's blizzard of news, it may help to ask which one we're watching - and whether the latest events suggest that the circle is bottoming out or just spinning faster.
The three downward spirals:
Confidence. All banks and insurance companies rely on the widespread perception that they're in good shape for the long term. Even the soundest firm couldn't repay all its obligations on short notice, but as long as everyone believes the firm is solid, it never has to. Yet just a tiny crack in the foundation of confidence can bring a whole institution down; that's the classic Depression bank run in which a mere rumor can start the vicious circle of withdrawals and falling confidence that results in bank failure.
Federal deposit insurance ended runs on commercial banks but not on other financial institutions, and that's what was about to doom Bear Stearns and AIG (AIG, Fortune 500) before the feds stepped in; Fannie Mae, Freddie Mac, and Lehman Brothers were apparently in deeper trouble, though they could have been rescued much less painfully if a confidence-sapping vicious circle hadn't turned their problems into crises.
Washington's giant bailout is intended to squelch a crisis of confidence in the whole U.S. financial sector. That's what's happening when the stocks of Goldman Sachs (GS, Fortune 500) and Morgan Stanley (MS, Fortune 500) get pounded, or when the prices of gold and Treasury bonds rocket. The less capital that goes into the sector, the weaker it becomes, driving capital further away, and so on.
Deleveraging. Lots of financial firms are concluding that they have too much debt. They're right. The paradox is that if they all try to do the right thing and pay down some debt, it makes them all worse off. To get the money to reduce debt, all are trying to sell financial assets. That glut of supply drives prices down, reducing the value of the assets the institutions still hold, so even after they've reduced debt, their debt ratios are no better than before, and they have to sell more assets, driving prices down further, and so on.
This vicious circle is different from the crisis of confidence in that it's based on real dollars, not psychology. Lehman's assets really did plunge in value, and everybody knew it. (That hard fact, of course, contributed to the confidence crisis.)
Housing. Since the housing market is the root of the whole mess, things won't get better until that market hits bottom. For now, it's still sinking, driven by the worst kind of vicious circle - a virtuous circle gone into reverse.
From about 2000 until 2006, U.S. home prices went up because they were going up. Yale professor Robert Shiller, who predicted the current housing collapse, notes that after easy credit launched the housing boom, consumers faced strong incentives to buy the most expensive house possible with the biggest mortgage they could get. That behavior then drove prices higher, strengthening the incentives, and so on.
Now it's the opposite. With prices falling, buyers figure they should wait to buy, while sellers rush to sell now; both behaviors push prices even lower, giving even greater incentive for the same behaviors.
What breaks vicious circles? In the economic world, massive federal intervention seems to be the only action that has worked. The Depression can be seen as one big vicious circle, with the New Deal (or World War II) as its antidote. On a smaller scale the Resolution Trust Corp. stopped the savings and loan crisis of the 1980s. Now Washington is feverishly debating the biggest intervention ever, reasoning that's what is needed for the biggest crisis ever.
Let's be careful. Did you know that you can buy credit default swaps on the United States? You can, and the price - indicating perceived risk - has been rising. A crisis of global confidence in the U.S. government is one vicious circle we really don't want to start spinning.
http://money.cnn.com/2008/09/29/magazines/fortune/colvin_economic_cycles.fortune/index.htm
The economy's 3 vicious cycles
The financial crisis consists of three related cycles spinning downward. Be careful trying to stop them.
The global financial tumult is so broad and deep that it's almost too big to grasp, so here's a way to think about it. Every financial crisis involves at least one vicious circle, a process in which things getting bad causes things to get worse.
Today's crisis consists of at least three big vicious circles all of which are meant to be checked by the government's proposed megafix. As we try to sort out each day's blizzard of news, it may help to ask which one we're watching - and whether the latest events suggest that the circle is bottoming out or just spinning faster.
The three downward spirals:
Confidence. All banks and insurance companies rely on the widespread perception that they're in good shape for the long term. Even the soundest firm couldn't repay all its obligations on short notice, but as long as everyone believes the firm is solid, it never has to. Yet just a tiny crack in the foundation of confidence can bring a whole institution down; that's the classic Depression bank run in which a mere rumor can start the vicious circle of withdrawals and falling confidence that results in bank failure.
Federal deposit insurance ended runs on commercial banks but not on other financial institutions, and that's what was about to doom Bear Stearns and AIG (AIG, Fortune 500) before the feds stepped in; Fannie Mae, Freddie Mac, and Lehman Brothers were apparently in deeper trouble, though they could have been rescued much less painfully if a confidence-sapping vicious circle hadn't turned their problems into crises.
Washington's giant bailout is intended to squelch a crisis of confidence in the whole U.S. financial sector. That's what's happening when the stocks of Goldman Sachs (GS, Fortune 500) and Morgan Stanley (MS, Fortune 500) get pounded, or when the prices of gold and Treasury bonds rocket. The less capital that goes into the sector, the weaker it becomes, driving capital further away, and so on.
Deleveraging. Lots of financial firms are concluding that they have too much debt. They're right. The paradox is that if they all try to do the right thing and pay down some debt, it makes them all worse off. To get the money to reduce debt, all are trying to sell financial assets. That glut of supply drives prices down, reducing the value of the assets the institutions still hold, so even after they've reduced debt, their debt ratios are no better than before, and they have to sell more assets, driving prices down further, and so on.
This vicious circle is different from the crisis of confidence in that it's based on real dollars, not psychology. Lehman's assets really did plunge in value, and everybody knew it. (That hard fact, of course, contributed to the confidence crisis.)
Housing. Since the housing market is the root of the whole mess, things won't get better until that market hits bottom. For now, it's still sinking, driven by the worst kind of vicious circle - a virtuous circle gone into reverse.
From about 2000 until 2006, U.S. home prices went up because they were going up. Yale professor Robert Shiller, who predicted the current housing collapse, notes that after easy credit launched the housing boom, consumers faced strong incentives to buy the most expensive house possible with the biggest mortgage they could get. That behavior then drove prices higher, strengthening the incentives, and so on.
Now it's the opposite. With prices falling, buyers figure they should wait to buy, while sellers rush to sell now; both behaviors push prices even lower, giving even greater incentive for the same behaviors.
What breaks vicious circles? In the economic world, massive federal intervention seems to be the only action that has worked. The Depression can be seen as one big vicious circle, with the New Deal (or World War II) as its antidote. On a smaller scale the Resolution Trust Corp. stopped the savings and loan crisis of the 1980s. Now Washington is feverishly debating the biggest intervention ever, reasoning that's what is needed for the biggest crisis ever.
Let's be careful. Did you know that you can buy credit default swaps on the United States? You can, and the price - indicating perceived risk - has been rising. A crisis of global confidence in the U.S. government is one vicious circle we really don't want to start spinning.
http://money.cnn.com/2008/09/29/magazines/fortune/colvin_economic_cycles.fortune/index.htm
亚洲周刊：七千亿美元只能遮盖泡沫
最新一期香港《亚洲周刊》发表南方朔撰写的文章说，美国七千亿美元的救市方案，并不能改善经济基本面，只是把资源错置到遮盖泡沫上。美元危机、全球物价上涨、资产大缩水的情况已开始出现，这一波金融危机距离结束仍极遥远。
文章摘录如下:
连续两星期，美国金融危机持续引爆，除了“二房危机”、雷曼兄弟、美国国际集团等外，还有更多金融机构在排队。由于逐一解救已不胜其苦，遂有了史上最大手笔的包装式救金融方案—美国财政部以七千亿美元收购金融机构的不良资产。由于金融财困的天文数字支出，美国联邦政府已调高举债上限，单单二零零九年度预算赤字即将高达八千亿至一兆美元之谱。
自去年次贷风暴出现，演变到今日的金融危机，美国及欧日等大国早已释出大约千亿美元救市，到了现在更节节加码，上周六大央行就已释出二千四百七十亿美元，现在又大手笔收购金融体系不良资产，即所谓的“流动性较差资产”。美国如此大手笔以财政筹码拯救出现危机的公司，这是典型的“利润归私，责任归公”，已严重违背资本主义的基本价值，因而美国此举的“道德风险”终将在某个特定时刻引发严重的争端，而除了这个非关金融的道德合法性问题外，美国此举对实质问题能够改善吗？恐怕也不容乐观。当汽球破了，不断的灌气却未堵住破洞，只是勉强维持汽球的形状而已。难怪评论家克鲁曼教授(Paul Krugman)会评说这是“用现金换垃圾”了。
首先，今天人们皆已知，今天的金融危机始于次贷风暴，而整个危机则和美国持续信用及借贷膨胀有关，这种膨胀则助长了房市及股市的投机潮，而金融体系则扮演着推波助澜、居间玩弄财务杠杆以图利的角色。它们借着所谓的“金融创新”将房贷业务包装成CDO(抵押债务证券)衍生性商品，而为了分担风险，又将 CDO再包装出售给全球其它金融机构。用常识语言来说，即是美国金融机构一直在市场操弄美国人的储蓄及投资，而后将这种操弄的空间扩大到其它国家。这也是法国总统萨尔科齐去年在八国峰会上严辞谴责替CDO背书的三大信用评级公司，认为这些金融问题本质上乃是诈欺，因而主张国际犯罪法庭加以调查的原因。正因这波危机是以全球为范围，经过近十余年来不断的膨胀，它涉及的证券金额已高达六十二兆美元至七十兆美元之间。这已是不可思议的天文数字，可以说美国即是漂浮在债务大海上的小舟。
因此，美国财政部伙同其它主要国家救金融，这种用预算赤字新债务企图救老债务的手段，仍不脱“举新债养旧债”的老模式，它可以造成危机缓和假象，但这种假象却不可能长久。这乃是七千亿美元救市的效果不应高估的原因。我们不能否认，共和党政府大手笔救市有其选举上的考虑，目前两党候选人正在拉锯，只要金融动荡缓和，共和党候选人未尝没有胜选的机会；但只要金融风暴不停，则共和党断无胜机。以政治考虑为出发点的救市，由于有着短线操作的意义，当然也不容乐观。
其次，随着大手笔救市的展开，另一个更严重的地雷已开始出现，那就是所谓的“美元危机”。自从布莱顿森林协议瓦解，美元与黄金脱钩，全球货币即进入一个不再有客观物质基础，而纯粹依靠大家对美元信心的程度而决定的所谓“美元时代”，由于美国的超级国力，而且它又是市场所谓的“最后购买者”﹐因而这等于给了美元无限度信用扩张的机会。而到了现在，美国七千亿美元救市，有可能导致美元又再大大的扩张，形同美国加紧在印制钞票。这乃是连续两个星期以来，英镑、欧元、澳纽币、加币、新加坡币、日圆等都告上涨的原因。除此之外。黄金、石油及其它商品原材料价格也都快速弹升，这也就是说︰当美国以赤字预算救市，大举增加美元供给，国际社会对美元的信心即下滑。它反映在美国社会上的，可能就是通货膨胀的压力也告增加。美国赤字救市，已使得长期以来即存在着的美元危机又再现风暴。因此，这波金融危机距离结束仍极遥远。
值得注意的，是投资银行高盛、摩根士丹利皆已决定改为传统银行集团，希望能借着银行功能来改善流动性问题。投资银行的终结，意谓华尔街玩弄财务杠杆而图利的时代已结束，这倒是个好趋势。近十余年来金融权力无限扩张，它们在美国及全球吹出了超级泡沫，那个时代已结束了。只是它们丢下了一个超级烂摊子，这是一场灾难，到现在仍然看不到尽头。目前美元贬值，物价上涨又抬头，在这个全球资产大缩水，消费动力已告失去的时候，再有美元贬值来雪上加霜，全球经济动荡已难避免，美国失业率连续八个月攀升，八月份失业率已达百分之六点一；工业生产则负成长百分之一点一，欧日则都已进入衰退。这意谓着一波大的经济紧缩已有可能出现。美国救市并不能改善经济基本面，只是把资源错置到遮盖泡沫上，几千亿美元的资源错置，又怎不使人慨叹呢？
http://www.zaobao.com/special/newspapers/2008/09/others080929ab.shtml
最新一期香港《亚洲周刊》发表南方朔撰写的文章说，美国七千亿美元的救市方案，并不能改善经济基本面，只是把资源错置到遮盖泡沫上。美元危机、全球物价上涨、资产大缩水的情况已开始出现，这一波金融危机距离结束仍极遥远。
文章摘录如下:
连续两星期，美国金融危机持续引爆，除了“二房危机”、雷曼兄弟、美国国际集团等外，还有更多金融机构在排队。由于逐一解救已不胜其苦，遂有了史上最大手笔的包装式救金融方案—美国财政部以七千亿美元收购金融机构的不良资产。由于金融财困的天文数字支出，美国联邦政府已调高举债上限，单单二零零九年度预算赤字即将高达八千亿至一兆美元之谱。
自去年次贷风暴出现，演变到今日的金融危机，美国及欧日等大国早已释出大约千亿美元救市，到了现在更节节加码，上周六大央行就已释出二千四百七十亿美元，现在又大手笔收购金融体系不良资产，即所谓的“流动性较差资产”。美国如此大手笔以财政筹码拯救出现危机的公司，这是典型的“利润归私，责任归公”，已严重违背资本主义的基本价值，因而美国此举的“道德风险”终将在某个特定时刻引发严重的争端，而除了这个非关金融的道德合法性问题外，美国此举对实质问题能够改善吗？恐怕也不容乐观。当汽球破了，不断的灌气却未堵住破洞，只是勉强维持汽球的形状而已。难怪评论家克鲁曼教授(Paul Krugman)会评说这是“用现金换垃圾”了。
首先，今天人们皆已知，今天的金融危机始于次贷风暴，而整个危机则和美国持续信用及借贷膨胀有关，这种膨胀则助长了房市及股市的投机潮，而金融体系则扮演着推波助澜、居间玩弄财务杠杆以图利的角色。它们借着所谓的“金融创新”将房贷业务包装成CDO(抵押债务证券)衍生性商品，而为了分担风险，又将 CDO再包装出售给全球其它金融机构。用常识语言来说，即是美国金融机构一直在市场操弄美国人的储蓄及投资，而后将这种操弄的空间扩大到其它国家。这也是法国总统萨尔科齐去年在八国峰会上严辞谴责替CDO背书的三大信用评级公司，认为这些金融问题本质上乃是诈欺，因而主张国际犯罪法庭加以调查的原因。正因这波危机是以全球为范围，经过近十余年来不断的膨胀，它涉及的证券金额已高达六十二兆美元至七十兆美元之间。这已是不可思议的天文数字，可以说美国即是漂浮在债务大海上的小舟。
因此，美国财政部伙同其它主要国家救金融，这种用预算赤字新债务企图救老债务的手段，仍不脱“举新债养旧债”的老模式，它可以造成危机缓和假象，但这种假象却不可能长久。这乃是七千亿美元救市的效果不应高估的原因。我们不能否认，共和党政府大手笔救市有其选举上的考虑，目前两党候选人正在拉锯，只要金融动荡缓和，共和党候选人未尝没有胜选的机会；但只要金融风暴不停，则共和党断无胜机。以政治考虑为出发点的救市，由于有着短线操作的意义，当然也不容乐观。
其次，随着大手笔救市的展开，另一个更严重的地雷已开始出现，那就是所谓的“美元危机”。自从布莱顿森林协议瓦解，美元与黄金脱钩，全球货币即进入一个不再有客观物质基础，而纯粹依靠大家对美元信心的程度而决定的所谓“美元时代”，由于美国的超级国力，而且它又是市场所谓的“最后购买者”﹐因而这等于给了美元无限度信用扩张的机会。而到了现在，美国七千亿美元救市，有可能导致美元又再大大的扩张，形同美国加紧在印制钞票。这乃是连续两个星期以来，英镑、欧元、澳纽币、加币、新加坡币、日圆等都告上涨的原因。除此之外。黄金、石油及其它商品原材料价格也都快速弹升，这也就是说︰当美国以赤字预算救市，大举增加美元供给，国际社会对美元的信心即下滑。它反映在美国社会上的，可能就是通货膨胀的压力也告增加。美国赤字救市，已使得长期以来即存在着的美元危机又再现风暴。因此，这波金融危机距离结束仍极遥远。
值得注意的，是投资银行高盛、摩根士丹利皆已决定改为传统银行集团，希望能借着银行功能来改善流动性问题。投资银行的终结，意谓华尔街玩弄财务杠杆而图利的时代已结束，这倒是个好趋势。近十余年来金融权力无限扩张，它们在美国及全球吹出了超级泡沫，那个时代已结束了。只是它们丢下了一个超级烂摊子，这是一场灾难，到现在仍然看不到尽头。目前美元贬值，物价上涨又抬头，在这个全球资产大缩水，消费动力已告失去的时候，再有美元贬值来雪上加霜，全球经济动荡已难避免，美国失业率连续八个月攀升，八月份失业率已达百分之六点一；工业生产则负成长百分之一点一，欧日则都已进入衰退。这意谓着一波大的经济紧缩已有可能出现。美国救市并不能改善经济基本面，只是把资源错置到遮盖泡沫上，几千亿美元的资源错置，又怎不使人慨叹呢？
http://www.zaobao.com/special/newspapers/2008/09/others080929ab.shtml
why fannie, freddie and aig all had to be bailed out pt1
IT’S THE DERIVATIVES, STUPID! - WHY FANNIE, FREDDIE AND AIG ALL HAD TO BE BAILED OUT
“I can calculate the movement of the stars, but not the madness of men.”
– Sir Isaac Newton, after losing a fortune in the South Sea bubble
Something extraordinary is going on with these government bailouts. In March 2008, the Federal Reserve extended a $55 billion loan to JPMorgan to “rescue” investment bank Bear Stearns from bankruptcy, a highly controversial move that tested the limits of the Federal Reserve Act. On September 7, 2008, the U.S. government seized private mortgage giants Fannie Mae and Freddie Mac and imposed a conservatorship, a form of bankruptcy; but rather than let the bankruptcy court sort out the assets among the claimants, the Treasury extended an unlimited credit line to the insolvent corporations and said it would exercise its authority to buy their stock, effectively nationalizing them. Now the Federal Reserve has announced that it is giving an $85 billion loan to American International Group (AIG), the world’s largest insurance company, in exchange for a nearly 80% stake in the insurer . . . .
The Fed is buying an insurance company? Where exactly is that covered in the Federal Reserve Act? The Associated Press calls it a “government takeover,” but this is not your ordinary “nationalization” like the purchase of Fannie/Freddie stock by the U.S. Treasury. The Federal Reserve has the power to print the national money supply, but it is not actually a part of the U.S. government. It is a private banking corporation owned by a consortium of private banks. The banking industry just bought the world’s largest insurance company, and they used federal money to do it. Yahoo Finance reported on September 17:
“The Treasury is setting up a temporary financing program at the Fed’s request. The program will auction Treasury bills to raise cash for the Fed’s use. The initiative aims to help the Fed manage its balance sheet following its efforts to enhance its liquidity facilities over the previous few quarters.”
Treasury bills are the I.O.U.s of the federal government. We the taxpayers are on the hook for the Fed’s “enhanced liquidity facilities,” meaning the loans it has been making to everyone in sight, bank or non-bank, exercising obscure provisions in the Federal Reserve Act that may or may not say they can do it. What’s going on here? Why not let the free market work? Bankruptcy courts know how to sort out assets and reorganize companies so they can operate again. Why the extraordinary measures for Fannie, Freddie and AIG?
The answer may have less to do with saving the insurance business, the housing market, or the Chinese investors clamoring for a bailout than with the greatest Ponzi scheme in history, one that is holding up the entire private global banking system. What had to be saved at all costs was not housing or the dollar but the financial derivatives industry; and the precipice from which it had to be saved was an “event of default” that could have collapsed a quadrillion dollar derivatives bubble, a collapse that could take the entire global banking system down with it.
The Anatomy of a Bubble
Until recently, most people had never even heard of derivatives; but in terms of money traded, these investments represent the biggest financial market in the world. Derivatives are financial instruments that have no intrinsic value but derive their value from something else. Basically, they are just bets. You can “hedge your bet” that something you own will go up by placing a side bet that it will go down. “Hedge funds” hedge bets in the derivatives market. Bets can be placed on anything, from the price of tea in China to the movements of specific markets.
“The point everyone misses,” wrote economist Robert Chapman a decade ago, “is that buying derivatives is not investing. It is gambling, insurance and high stakes bookmaking. Derivatives create nothing.”1 They not only create nothing, but they serve to enrich non-producers at the expense of the people who do create real goods and services. In congressional hearings in the early 1990s, derivatives trading was challenged as being an illegal form of gambling. But the practice was legitimized by Fed Chairman Alan Greenspan, who not only lent legal and regulatory support to the trade but actively promoted derivatives as a way to improve “risk management.” Partly, this was to boost the flagging profits of the banks; and at the larger banks and dealers, it worked. But the cost was an increase in risk to the financial system as a whole.2
Since then, derivative trades have grown exponentially, until now they are larger than the entire global economy. The Bank for International Settlements recently reported that total derivatives trades exceeded one quadrillion dollars – that’s 1,000 trillion dollars.3 How is that figure even possible? The gross domestic product of all the countries in the world is only about 60 trillion dollars. The answer is that gamblers can bet as much as they want. They can bet money they don’t have, and that is where the huge increase in risk comes in.
Credit default swaps (CDS) are the most widely traded form of credit derivative. CDS are bets between two parties on whether or not a company will default on its bonds. In a typical default swap, the “protection buyer” gets a large payoff from the “protection seller” if the company defaults within a certain period of time, while the “protection seller” collects periodic payments from the “protection buyer” for assuming the risk of default. CDS thus resemble insurance policies, but there is no requirement to actually hold any asset or suffer any loss, so CDS are widely used just to increase profits by gambling on market changes. In one blogger’s example, a hedge fund could sit back and collect $320,000 a year in premiums just for selling “protection” on a risky BBB junk bond. The premiums are “free” money – free until the bond actually goes into default, when the hedge fund could be on the hook for $100 million in claims.
And there’s the catch: what if the hedge fund doesn’t have the $100 million? The fund’s corporate shell or limited partnership is put into bankruptcy; but both parties are claiming the derivative as an asset on their books, which they now have to write down. Players who have “hedged their bets” by betting both ways cannot collect on their winning bets; and that means they cannot afford to pay their losing bets, causing other players to also default on their bets.
The dominos go down in a cascade of cross-defaults that infects the whole banking industry and jeopardizes the global pyramid scheme. The potential for this sort of nuclear reaction was what prompted billionaire investor Warren Buffett to call derivatives “weapons of financial mass destruction.” It is also why the banking system cannot let a major derivatives player go down, and it is the banking system that calls the shots. The Federal Reserve is literally owned by a conglomerate of banks; and Hank Paulson, who heads the U.S. Treasury, entered that position through the revolving door of investment bank Goldman Sachs, where he was formerly CEO.
The Best Game in Town
In an article on FinancialSense.com on September 9, Daniel Amerman maintains that the government’s takeover of Fannie Mae and Freddie Mac was not actually a bailout of the mortgage giants. It was a bailout of the financial derivatives industry, which was faced with a $1.4 trillion “event of default” that could have bankrupted Wall Street and much of the rest of the financial world. To explain the enormous risk involved, Amerman posits a scenario in which the mortgage giants are not bailed out by the government. When they default on the $5 trillion in bonds and mortgage-backed securities they own or guarantee, settlements are immediately triggered on $1.4 trillion in credit default swaps entered into by major financial firms, which have promised to make good on Fannie/Freddie defaulted bonds in return for very lucrative fee income and multi-million dollar bonuses. The value of the vulnerable bonds plummets by 70%, causing $1 trillion (70% of $1.4 trillion) to be due to the “protection buyers.” This is more money, however, than the already-strapped financial institutions have to spare. The CDS sellers are highly leveraged themselves, which means they depend on huge day-to-day lines of credit just to stay afloat. When their creditors see the trillion dollar hit coming, they pull their financing, leaving the strapped institutions with massive portfolios of illiquid assets. The dreaded cascade of cross-defaults begins, until nearly every major investment bank and commercial bank is unable to meet its obligations. This triggers another massive round of CDS events, going to $10 trillion, then $20 trillion. The financial centers become insolvent, the markets have to be shut down, and when they open months later, the stock market has been crushed. The federal government and the financiers pulling its strings naturally feel compelled to step in to prevent such a disaster, even though this rewards the profligate speculators at the expense of the Fannie/Freddie shareholders who will get wiped out. Amerman concludes:
“t’s the best game in town. Take a huge amount of risk, be paid exceedingly well for it and if you screw up -- you have absolute proof that the government will come in and bail you out at the expense of the rest of the population (who did not share in your profits in the first place).”
IT’S THE DERIVATIVES, STUPID! - WHY FANNIE, FREDDIE AND AIG ALL HAD TO BE BAILED OUT
“I can calculate the movement of the stars, but not the madness of men.”
– Sir Isaac Newton, after losing a fortune in the South Sea bubble
Something extraordinary is going on with these government bailouts. In March 2008, the Federal Reserve extended a $55 billion loan to JPMorgan to “rescue” investment bank Bear Stearns from bankruptcy, a highly controversial move that tested the limits of the Federal Reserve Act. On September 7, 2008, the U.S. government seized private mortgage giants Fannie Mae and Freddie Mac and imposed a conservatorship, a form of bankruptcy; but rather than let the bankruptcy court sort out the assets among the claimants, the Treasury extended an unlimited credit line to the insolvent corporations and said it would exercise its authority to buy their stock, effectively nationalizing them. Now the Federal Reserve has announced that it is giving an $85 billion loan to American International Group (AIG), the world’s largest insurance company, in exchange for a nearly 80% stake in the insurer . . . .
The Fed is buying an insurance company? Where exactly is that covered in the Federal Reserve Act? The Associated Press calls it a “government takeover,” but this is not your ordinary “nationalization” like the purchase of Fannie/Freddie stock by the U.S. Treasury. The Federal Reserve has the power to print the national money supply, but it is not actually a part of the U.S. government. It is a private banking corporation owned by a consortium of private banks. The banking industry just bought the world’s largest insurance company, and they used federal money to do it. Yahoo Finance reported on September 17:
“The Treasury is setting up a temporary financing program at the Fed’s request. The program will auction Treasury bills to raise cash for the Fed’s use. The initiative aims to help the Fed manage its balance sheet following its efforts to enhance its liquidity facilities over the previous few quarters.”
Treasury bills are the I.O.U.s of the federal government. We the taxpayers are on the hook for the Fed’s “enhanced liquidity facilities,” meaning the loans it has been making to everyone in sight, bank or non-bank, exercising obscure provisions in the Federal Reserve Act that may or may not say they can do it. What’s going on here? Why not let the free market work? Bankruptcy courts know how to sort out assets and reorganize companies so they can operate again. Why the extraordinary measures for Fannie, Freddie and AIG?
The answer may have less to do with saving the insurance business, the housing market, or the Chinese investors clamoring for a bailout than with the greatest Ponzi scheme in history, one that is holding up the entire private global banking system. What had to be saved at all costs was not housing or the dollar but the financial derivatives industry; and the precipice from which it had to be saved was an “event of default” that could have collapsed a quadrillion dollar derivatives bubble, a collapse that could take the entire global banking system down with it.
The Anatomy of a Bubble
Until recently, most people had never even heard of derivatives; but in terms of money traded, these investments represent the biggest financial market in the world. Derivatives are financial instruments that have no intrinsic value but derive their value from something else. Basically, they are just bets. You can “hedge your bet” that something you own will go up by placing a side bet that it will go down. “Hedge funds” hedge bets in the derivatives market. Bets can be placed on anything, from the price of tea in China to the movements of specific markets.
“The point everyone misses,” wrote economist Robert Chapman a decade ago, “is that buying derivatives is not investing. It is gambling, insurance and high stakes bookmaking. Derivatives create nothing.”1 They not only create nothing, but they serve to enrich non-producers at the expense of the people who do create real goods and services. In congressional hearings in the early 1990s, derivatives trading was challenged as being an illegal form of gambling. But the practice was legitimized by Fed Chairman Alan Greenspan, who not only lent legal and regulatory support to the trade but actively promoted derivatives as a way to improve “risk management.” Partly, this was to boost the flagging profits of the banks; and at the larger banks and dealers, it worked. But the cost was an increase in risk to the financial system as a whole.2
Since then, derivative trades have grown exponentially, until now they are larger than the entire global economy. The Bank for International Settlements recently reported that total derivatives trades exceeded one quadrillion dollars – that’s 1,000 trillion dollars.3 How is that figure even possible? The gross domestic product of all the countries in the world is only about 60 trillion dollars. The answer is that gamblers can bet as much as they want. They can bet money they don’t have, and that is where the huge increase in risk comes in.
Credit default swaps (CDS) are the most widely traded form of credit derivative. CDS are bets between two parties on whether or not a company will default on its bonds. In a typical default swap, the “protection buyer” gets a large payoff from the “protection seller” if the company defaults within a certain period of time, while the “protection seller” collects periodic payments from the “protection buyer” for assuming the risk of default. CDS thus resemble insurance policies, but there is no requirement to actually hold any asset or suffer any loss, so CDS are widely used just to increase profits by gambling on market changes. In one blogger’s example, a hedge fund could sit back and collect $320,000 a year in premiums just for selling “protection” on a risky BBB junk bond. The premiums are “free” money – free until the bond actually goes into default, when the hedge fund could be on the hook for $100 million in claims.
And there’s the catch: what if the hedge fund doesn’t have the $100 million? The fund’s corporate shell or limited partnership is put into bankruptcy; but both parties are claiming the derivative as an asset on their books, which they now have to write down. Players who have “hedged their bets” by betting both ways cannot collect on their winning bets; and that means they cannot afford to pay their losing bets, causing other players to also default on their bets.
The dominos go down in a cascade of cross-defaults that infects the whole banking industry and jeopardizes the global pyramid scheme. The potential for this sort of nuclear reaction was what prompted billionaire investor Warren Buffett to call derivatives “weapons of financial mass destruction.” It is also why the banking system cannot let a major derivatives player go down, and it is the banking system that calls the shots. The Federal Reserve is literally owned by a conglomerate of banks; and Hank Paulson, who heads the U.S. Treasury, entered that position through the revolving door of investment bank Goldman Sachs, where he was formerly CEO.
The Best Game in Town
In an article on FinancialSense.com on September 9, Daniel Amerman maintains that the government’s takeover of Fannie Mae and Freddie Mac was not actually a bailout of the mortgage giants. It was a bailout of the financial derivatives industry, which was faced with a $1.4 trillion “event of default” that could have bankrupted Wall Street and much of the rest of the financial world. To explain the enormous risk involved, Amerman posits a scenario in which the mortgage giants are not bailed out by the government. When they default on the $5 trillion in bonds and mortgage-backed securities they own or guarantee, settlements are immediately triggered on $1.4 trillion in credit default swaps entered into by major financial firms, which have promised to make good on Fannie/Freddie defaulted bonds in return for very lucrative fee income and multi-million dollar bonuses. The value of the vulnerable bonds plummets by 70%, causing $1 trillion (70% of $1.4 trillion) to be due to the “protection buyers.” This is more money, however, than the already-strapped financial institutions have to spare. The CDS sellers are highly leveraged themselves, which means they depend on huge day-to-day lines of credit just to stay afloat. When their creditors see the trillion dollar hit coming, they pull their financing, leaving the strapped institutions with massive portfolios of illiquid assets. The dreaded cascade of cross-defaults begins, until nearly every major investment bank and commercial bank is unable to meet its obligations. This triggers another massive round of CDS events, going to $10 trillion, then $20 trillion. The financial centers become insolvent, the markets have to be shut down, and when they open months later, the stock market has been crushed. The federal government and the financiers pulling its strings naturally feel compelled to step in to prevent such a disaster, even though this rewards the profligate speculators at the expense of the Fannie/Freddie shareholders who will get wiped out. Amerman concludes:
“t’s the best game in town. Take a huge amount of risk, be paid exceedingly well for it and if you screw up -- you have absolute proof that the government will come in and bail you out at the expense of the rest of the population (who did not share in your profits in the first place).”
why fannie, freddie and aig all had to be bailed out pt2
Desperate Measures for Desperate Times
It was the best game in town until September 14, when Treasury Secretary Paulson, Fed Chairman Ben Bernanke, and New York Fed Head Tim Geithner closed the bailout window to Lehman Brothers, a 158-year-old Wall Street investment firm and major derivatives player. Why? “There is no political will for a federal bailout,” said Geithner. Bailing out Fannie and Freddie had created a furor of protest, and the taxpayers could not afford to underwrite the whole quadrillion dollar derivatives bubble. The line had to be drawn somewhere, and this was apparently it.
Or was the Fed just saving its ammunition for AIG? Recent downgrades in AIG’s ratings meant that the counterparties to its massive derivatives contracts could force it to come up with $10.5 billion in additional capital reserves immediately or file for bankruptcy. Treasury Secretary Paulson resisted advancing taxpayer money; but on Monday, September 15, stock trading was ugly, with the S & P 500 registering the largest one-day percent drop since September 11, 2001. Alan Kohler wrote in the Australian Business Spectator:
“t’s unlikely to be a slow-motion train wreck this time. With Lehman in liquidation, and Washington Mutual and AIG on the brink, the credit market would likely shut down entirely and interbank lending would cease.”5
Kohler quoted the September 14 newsletter of Professor Nouriel Roubini, who has a popular website called Global EconoMonitor. Roubini warned:
“What we are facing now is the beginning of the unravelling and collapse of the entire shadow financial system, a system of institutions (broker dealers, hedge funds, private equity funds, SIVs, conduits, etc.) that look like banks (as they borrow short, are highly leveraged and lend and invest long and in illiquid ways) and thus are highly vulnerable to bank-like runs; but unlike banks they are not properly regulated and supervised, they don’t have access to deposit insurance and don’t have access to the lender of last resort support of the central bank.”
The risk posed to the system was evidently too great. On September 16, while Barclay’s Bank was offering to buy the banking divisions of Lehman Brothers, the Federal Reserve agreed to bail out AIG in return for 80% of its stock. Why the Federal Reserve instead of the U.S. Treasury? Perhaps because the Treasury would take too much heat for putting yet more taxpayer money on the line. The Federal Reserve could do it quietly through its “Open Market Operations,” the ruse by which it “monetizes” government debt, turning Treasury bills (government I.O.U.s) into dollars. The taxpayers would still have to pick up the tab, but the Federal Reserve would not have to get approval from Congress first.
Time for a 21st Century New Deal?
Another hole has been plugged in a very leaky boat, keeping it afloat another day; but how long can these stopgap measures be sustained? Professor Roubini maintains:
“The step by step, ad hoc and non-holistic approach of Fed and Treasury to crisis management has been a failure. . . . [P]lugging and filling one hole at [a] time is useless when the entire system of levies is collapsing in the perfect financial storm of the century. A much more radical, holistic and systemic approach to crisis management is now necessary.”6
We may soon hear that “the credit market is frozen” – that there is no money to keep homeowners in their homes, workers gainfully employed, or infrastructure maintained. But this is not true. The underlying source of all money is government credit – our own public credit. We don’t need to borrow it from the Chinese or the Saudis or private banks. The government can issue its own credit – the “full faith and credit of the United States.” That was the model followed by the Pennsylvania colonists in the eighteenth century, and it worked brilliantly well. Before the provincial government came up with this plan, the Pennsylvania economy was languishing. There was little gold to conduct trade, and the British bankers were charging 8% interest to borrow what was available. The government solved the credit problem by issuing and lending its own paper scrip. A publicly-owned bank lent the money to farmers at 5% interest. The money was returned to the government, preventing inflation; and the interest paid the government’s expenses, replacing taxes. During the period the system was in place, the economy flourished, prices remained stable, and the Pennsylvania colonists paid no taxes at all. (For more on this, see E. Brown, “Sustainable Energy Development: How Costs Can Be Cut in Half,” webofdebt.com/articles, November 5, 2007.)
Today’s credit crisis is very similar to that facing Herbert Hoover and Franklin Roosevelt in the 1930s. In 1932, President Hoover set up the Reconstruction Finance Corporation (RFC) as a federally-owned bank that would bail out commercial banks by extending loans to them, much as the privately-owned Federal Reserve is doing today. But like today, Hoover’s ploy failed. The banks did not need more loans; they were already drowning in debt. They needed customers with money to spend and invest. President Roosevelt used Hoover’s new government-owned lending facility to extend loans where they were needed most – for housing, agriculture and industry. Many new federal agencies were set up and funded by the RFC, including the HOLC (Home Owners Loan Corporation) and Fannie Mae (the Federal National Mortgage Association, which was then a government-owned agency). In the 1940s, the RFC went into overdrive funding the infrastructure necessary for the U.S. to participate in World War II, setting the country up with the infrastructure it needed to become the world’s industrial leader after the war.
The RFC was a government-owned bank that sidestepped the privately-owned Federal Reserve; but unlike the Pennsylvania provincial government, which originated the money it lent, the RFC had to borrow the money first. The RFC was funded by issuing government bonds and relending the proceeds. Then as now, new money entered the money supply chiefly in the form of private bank loans. In a “fractional reserve” banking system, banks are allowed to lend their “reserves” many times over, effectively multiplying the amount of money in circulation. Today a system of public banks might be set up on the model of the RFC to fund productive endeavors – industry, agriculture, housing, energy -- but we could go a step further than the RFC and give the new public banks the power to create credit themselves, just as the Pennsylvania government did and as private banks do now. At the rate banks are going into FDIC receivership, the federal government will soon own a string of banks, which it might as well put to productive use. Establishing a new RFC might be an easier move politically than trying to nationalize the Federal Reserve, but that is what should properly, logically be done. If we the taxpayers are putting up the money for the Fed to own the world’s largest insurance company, we should own the Fed.
Proposals for reforming the banking system are not even on the radar screen of Prime Time politics today; but the current system is collapsing at train-wreck speed, and the “change” called for in Washington may soon be taking a direction undreamt of a few years ago. We need to stop funding the culprits who brought us this debacle at our expense. We need a public banking system that makes a cost-effective credit mechanism available for homeowners, manufacturing, renewable energy, and infrastructure; and the first step to making it cost-effective is to strip out the swarms of gamblers, fraudsters and profiteers now gaming the system.
1 Quoted in James Wesley, “Derivatives – The Mystery Man Who’ll Break the Global Bank at Monte Carlo,” SurvivalBlog.com (September 2006).
2 “Killer Derivatives, Zombie CDOs and Basel Too?”, Institutional Risk Analytics(August 14, 2007).
3 Kevin DeMeritt, “$1.14 Quadrillion in Derivatives – What Goes Up . . . ,” Gold-Eagle.com (June 16, 2008).
4 Daniel Amerman, “The Hidden Bailout of $1.4 Trillion in Fannie/Freddie Credit-Default Swaps,” FinancialSense.com (September 10, 2008).
5 Alan Kohler, “Lehman End-game,” Business Spectator (Australia) (September 15, 2008).
6 Ibid.
http://www.webofdebt.com/articles/its_the_derivatives.php
Desperate Measures for Desperate Times
It was the best game in town until September 14, when Treasury Secretary Paulson, Fed Chairman Ben Bernanke, and New York Fed Head Tim Geithner closed the bailout window to Lehman Brothers, a 158-year-old Wall Street investment firm and major derivatives player. Why? “There is no political will for a federal bailout,” said Geithner. Bailing out Fannie and Freddie had created a furor of protest, and the taxpayers could not afford to underwrite the whole quadrillion dollar derivatives bubble. The line had to be drawn somewhere, and this was apparently it.
Or was the Fed just saving its ammunition for AIG? Recent downgrades in AIG’s ratings meant that the counterparties to its massive derivatives contracts could force it to come up with $10.5 billion in additional capital reserves immediately or file for bankruptcy. Treasury Secretary Paulson resisted advancing taxpayer money; but on Monday, September 15, stock trading was ugly, with the S & P 500 registering the largest one-day percent drop since September 11, 2001. Alan Kohler wrote in the Australian Business Spectator:
“t’s unlikely to be a slow-motion train wreck this time. With Lehman in liquidation, and Washington Mutual and AIG on the brink, the credit market would likely shut down entirely and interbank lending would cease.”5
Kohler quoted the September 14 newsletter of Professor Nouriel Roubini, who has a popular website called Global EconoMonitor. Roubini warned:
“What we are facing now is the beginning of the unravelling and collapse of the entire shadow financial system, a system of institutions (broker dealers, hedge funds, private equity funds, SIVs, conduits, etc.) that look like banks (as they borrow short, are highly leveraged and lend and invest long and in illiquid ways) and thus are highly vulnerable to bank-like runs; but unlike banks they are not properly regulated and supervised, they don’t have access to deposit insurance and don’t have access to the lender of last resort support of the central bank.”
The risk posed to the system was evidently too great. On September 16, while Barclay’s Bank was offering to buy the banking divisions of Lehman Brothers, the Federal Reserve agreed to bail out AIG in return for 80% of its stock. Why the Federal Reserve instead of the U.S. Treasury? Perhaps because the Treasury would take too much heat for putting yet more taxpayer money on the line. The Federal Reserve could do it quietly through its “Open Market Operations,” the ruse by which it “monetizes” government debt, turning Treasury bills (government I.O.U.s) into dollars. The taxpayers would still have to pick up the tab, but the Federal Reserve would not have to get approval from Congress first.
Time for a 21st Century New Deal?
Another hole has been plugged in a very leaky boat, keeping it afloat another day; but how long can these stopgap measures be sustained? Professor Roubini maintains:
“The step by step, ad hoc and non-holistic approach of Fed and Treasury to crisis management has been a failure. . . . [P]lugging and filling one hole at [a] time is useless when the entire system of levies is collapsing in the perfect financial storm of the century. A much more radical, holistic and systemic approach to crisis management is now necessary.”6
We may soon hear that “the credit market is frozen” – that there is no money to keep homeowners in their homes, workers gainfully employed, or infrastructure maintained. But this is not true. The underlying source of all money is government credit – our own public credit. We don’t need to borrow it from the Chinese or the Saudis or private banks. The government can issue its own credit – the “full faith and credit of the United States.” That was the model followed by the Pennsylvania colonists in the eighteenth century, and it worked brilliantly well. Before the provincial government came up with this plan, the Pennsylvania economy was languishing. There was little gold to conduct trade, and the British bankers were charging 8% interest to borrow what was available. The government solved the credit problem by issuing and lending its own paper scrip. A publicly-owned bank lent the money to farmers at 5% interest. The money was returned to the government, preventing inflation; and the interest paid the government’s expenses, replacing taxes. During the period the system was in place, the economy flourished, prices remained stable, and the Pennsylvania colonists paid no taxes at all. (For more on this, see E. Brown, “Sustainable Energy Development: How Costs Can Be Cut in Half,” webofdebt.com/articles, November 5, 2007.)
Today’s credit crisis is very similar to that facing Herbert Hoover and Franklin Roosevelt in the 1930s. In 1932, President Hoover set up the Reconstruction Finance Corporation (RFC) as a federally-owned bank that would bail out commercial banks by extending loans to them, much as the privately-owned Federal Reserve is doing today. But like today, Hoover’s ploy failed. The banks did not need more loans; they were already drowning in debt. They needed customers with money to spend and invest. President Roosevelt used Hoover’s new government-owned lending facility to extend loans where they were needed most – for housing, agriculture and industry. Many new federal agencies were set up and funded by the RFC, including the HOLC (Home Owners Loan Corporation) and Fannie Mae (the Federal National Mortgage Association, which was then a government-owned agency). In the 1940s, the RFC went into overdrive funding the infrastructure necessary for the U.S. to participate in World War II, setting the country up with the infrastructure it needed to become the world’s industrial leader after the war.
The RFC was a government-owned bank that sidestepped the privately-owned Federal Reserve; but unlike the Pennsylvania provincial government, which originated the money it lent, the RFC had to borrow the money first. The RFC was funded by issuing government bonds and relending the proceeds. Then as now, new money entered the money supply chiefly in the form of private bank loans. In a “fractional reserve” banking system, banks are allowed to lend their “reserves” many times over, effectively multiplying the amount of money in circulation. Today a system of public banks might be set up on the model of the RFC to fund productive endeavors – industry, agriculture, housing, energy -- but we could go a step further than the RFC and give the new public banks the power to create credit themselves, just as the Pennsylvania government did and as private banks do now. At the rate banks are going into FDIC receivership, the federal government will soon own a string of banks, which it might as well put to productive use. Establishing a new RFC might be an easier move politically than trying to nationalize the Federal Reserve, but that is what should properly, logically be done. If we the taxpayers are putting up the money for the Fed to own the world’s largest insurance company, we should own the Fed.
Proposals for reforming the banking system are not even on the radar screen of Prime Time politics today; but the current system is collapsing at train-wreck speed, and the “change” called for in Washington may soon be taking a direction undreamt of a few years ago. We need to stop funding the culprits who brought us this debacle at our expense. We need a public banking system that makes a cost-effective credit mechanism available for homeowners, manufacturing, renewable energy, and infrastructure; and the first step to making it cost-effective is to strip out the swarms of gamblers, fraudsters and profiteers now gaming the system.
1 Quoted in James Wesley, “Derivatives – The Mystery Man Who’ll Break the Global Bank at Monte Carlo,” SurvivalBlog.com (September 2006).
2 “Killer Derivatives, Zombie CDOs and Basel Too?”, Institutional Risk Analytics(August 14, 2007).
3 Kevin DeMeritt, “$1.14 Quadrillion in Derivatives – What Goes Up . . . ,” Gold-Eagle.com (June 16, 2008).
4 Daniel Amerman, “The Hidden Bailout of $1.4 Trillion in Fannie/Freddie Credit-Default Swaps,” FinancialSense.com (September 10, 2008).
5 Alan Kohler, “Lehman End-game,” Business Spectator (Australia) (September 15, 2008).
6 Ibid.
http://www.webofdebt.com/articles/its_the_derivatives.php
It's not the Forclosures- it's the deivatives; It is actually related
It's not the Forclosures- it's the deivatives; It is actually related
We are in the midst of the collapse of a roughly $1 QUADRILLION (1000 trillion or 1,000,000 billion) notional derivatives bubble. The Paulson plan is designed to save this derivatives bubble, or at least the underlying bets. Many in congress and mainstreet want to add a component to the plan to help slow foreclosures, possibly by modifying the terms of mortgages. This could include interest rate reductions, principal forgiveness, term increases, freezes/holds, etc.
The problem is that the mortgages were securitized into mortgage backed securities, which were then pooled into collateralized debt obligations, which then tie into structured investment vehicles (the few which are left), hedge funds, and additional derivatives vehicles. Many of the MBS themselves are backed by credit default swaps, another type of credit derivative. Many of the above are highly leveraged. Some depend on a combination of leverage and a small interest difference (say 0.5% or less) to keep the derivative instrument alive. If the terms of the frozen mortgages start getting modified without new counter funds and fees to add new money (i.e., creating new mortgages at prevailing rates and new balancing derivatives contracts), then the whole paper ponzi-scheme could start collapsing under the weight of leverage, negative arbitrage, rating decay, etc. As a chain of counterparties start defaulting the whole bubble bursts. The derivatives bubble, since it is leveraged, will likely burst faster if the mortgages are modified then the slow death of the nation by foreclosure.
What this means is that we appear to be in a situation that pits Main Street against Wall Street (at best to buy additional time to solve the unsolvable problem). We can either save the derivatives bubble (actually opush out its collapse further), but slowly destroy Main Street, or we can save Main Street, but put the derivatives bubble into bankruptcy. It does not seem likely we can do both. I.e., we can have a Great Depression II, or we can have Congress utilize their Constitutional authority to create a new monetary arrangement.
Killing Main Street is not an option. The US has changed national banking multiple times in its history. We can do it again. Right now, though the financial system is failing, the houses still stand and generally are occupied, cars are on the streets, most people are working, food is being grown and distributed, weddings and births continue,etc. In other words, though on the edge, the underlying economy and society are still functioning. With the financial systems of Europe an Asia following in our decline, it seems likely that international cooperation to replace the currently failing fiat based central banking system is obtainable.
Tell your Congressmen to choose Main Street, not Wall Street. Tell them to Take Back The Fed.
http://www.financialblackmail.us/essay.htm
It's not the Forclosures- it's the deivatives; It is actually related
We are in the midst of the collapse of a roughly $1 QUADRILLION (1000 trillion or 1,000,000 billion) notional derivatives bubble. The Paulson plan is designed to save this derivatives bubble, or at least the underlying bets. Many in congress and mainstreet want to add a component to the plan to help slow foreclosures, possibly by modifying the terms of mortgages. This could include interest rate reductions, principal forgiveness, term increases, freezes/holds, etc.
The problem is that the mortgages were securitized into mortgage backed securities, which were then pooled into collateralized debt obligations, which then tie into structured investment vehicles (the few which are left), hedge funds, and additional derivatives vehicles. Many of the MBS themselves are backed by credit default swaps, another type of credit derivative. Many of the above are highly leveraged. Some depend on a combination of leverage and a small interest difference (say 0.5% or less) to keep the derivative instrument alive. If the terms of the frozen mortgages start getting modified without new counter funds and fees to add new money (i.e., creating new mortgages at prevailing rates and new balancing derivatives contracts), then the whole paper ponzi-scheme could start collapsing under the weight of leverage, negative arbitrage, rating decay, etc. As a chain of counterparties start defaulting the whole bubble bursts. The derivatives bubble, since it is leveraged, will likely burst faster if the mortgages are modified then the slow death of the nation by foreclosure.
What this means is that we appear to be in a situation that pits Main Street against Wall Street (at best to buy additional time to solve the unsolvable problem). We can either save the derivatives bubble (actually opush out its collapse further), but slowly destroy Main Street, or we can save Main Street, but put the derivatives bubble into bankruptcy. It does not seem likely we can do both. I.e., we can have a Great Depression II, or we can have Congress utilize their Constitutional authority to create a new monetary arrangement.
Killing Main Street is not an option. The US has changed national banking multiple times in its history. We can do it again. Right now, though the financial system is failing, the houses still stand and generally are occupied, cars are on the streets, most people are working, food is being grown and distributed, weddings and births continue,etc. In other words, though on the edge, the underlying economy and society are still functioning. With the financial systems of Europe an Asia following in our decline, it seems likely that international cooperation to replace the currently failing fiat based central banking system is obtainable.
Tell your Congressmen to choose Main Street, not Wall Street. Tell them to Take Back The Fed.
http://www.financialblackmail.us/essay.htm
FDIC limit officially raised to $250,000
Federal regulators formally approve the temporary increase from $100,000.
October 10, 2008: 6:18 PM ET
WASHINGTON (AP) -- The Federal Deposit Insurance Corp. (FDIC) on Friday formally approved the increased insurance limit of $250,000 per regular account that was part of the financial rescue legislation enacted last week.
The FDIC board approved the temporary increase per account in a vote at a meeting. The new limits, which extend through the end of next year, also provide for an increase in the insurance ceiling on joint deposit accounts to $200,000 per co-owner of the account from the current $100,000. The limit for retirement accounts held in banks remains at $250,000.
The FDIC board on Tuesday approved a new plan for rebuilding the deposit insurance fund that would more than double the banking industry's average premiums next year. It could be formally adopted sometime after a 30-day public comment period.
The proposed increases in bank premiums would cover only up to the previous insured $100,000 limit per regular deposit account.
Thirteen federally insured banks and savings and loans - including two major thrifts - have failed this year, and more collapses are expected. The deposit insurance fund is now at $45.2 billion - below the minimum target set by Congress and the lowest level since 2003.
The FDIC plan aims to rebuild it within five years to an even higher level than the law requires.
Sg only 20k :(
Federal regulators formally approve the temporary increase from $100,000.
October 10, 2008: 6:18 PM ET
WASHINGTON (AP) -- The Federal Deposit Insurance Corp. (FDIC) on Friday formally approved the increased insurance limit of $250,000 per regular account that was part of the financial rescue legislation enacted last week.
The FDIC board approved the temporary increase per account in a vote at a meeting. The new limits, which extend through the end of next year, also provide for an increase in the insurance ceiling on joint deposit accounts to $200,000 per co-owner of the account from the current $100,000. The limit for retirement accounts held in banks remains at $250,000.
The FDIC board on Tuesday approved a new plan for rebuilding the deposit insurance fund that would more than double the banking industry's average premiums next year. It could be formally adopted sometime after a 30-day public comment period.
The proposed increases in bank premiums would cover only up to the previous insured $100,000 limit per regular deposit account.
Thirteen federally insured banks and savings and loans - including two major thrifts - have failed this year, and more collapses are expected. The deposit insurance fund is now at $45.2 billion - below the minimum target set by Congress and the lowest level since 2003.
The FDIC plan aims to rebuild it within five years to an even higher level than the law requires.
Sg only 20k :(
Business lending falls again
NEW YORK (CNNMoney.com) -- The market for commercial paper, a key form of lending to major businesses and banks, continued to shrink in the past week, according to a report from the Federal Reserve Thursday.
The latest figures released Thursday morning show total commercial paper outstanding fell by $56.4 billion, or 3.5%, in just the past week, to $1.55 trillion.
The decline marks the fourth straight week of declines, a fall that has reduced total commercial paper outstanding by $264.4 billion, or 15%, as the credit crisis escalated on Wall Street.
"What that tells you is that corporations that have generally been able to borrow in that market have been frozen out," said Lyle Gramley, a former Fed governor now serving as an economist with the Stanford Group.
Commercial paper is sold by major corporations and most of the nation's leading financial institutions. They use the proceeds to fund day-to-day business operations. It is bought primarily by money market fund managers and other institutional investors.
"It's basically the checking accounting for business," said Kevin Giddis, head of fixed-income sales trading and research for investment firm Morgan Keegan. "It is literally how they operate on a day-to-day cash basis. It's their main funding source."
The sharp drop in commercial lending in recent weeks prompted the Fed to announce an unprecedented program to have the central bank start to buy the paper, a move that essentially will have the Fed lending money directly to many major companies.
Many details of the Fed's plans are still being worked out. Fed officials who briefed reporters on the program Tuesday said they hoped just the announcement of the Fed's plans to buy commercial paper would assure investors to return to that market knowing that the central bank would soon be a backstop.
Gramley said he's hopeful that the Fed's commercial paper program will start to solve the problem soon, but that it didn't have enough time to have any meaningful impact on this latest reading.
"I would say probably by next week's numbers, things will be beginning to settle down," he said.
For investors, commercial paper was considered a very safe investment to purchase, even if most of it was backed by little more than the company's and banks good reputation. The strength of the firms selling the paper meant it could be easily resold.
But since the bankruptcy of Lehman on Sept. 15, many leading buyers of commercial paper have been afraid to play in the market, shifting their investments to safer U.S. Treasurys instead. No one wanted to get caught holding commercial paper for a company or financial institution that suddenly found itself in trouble.
And the seize-up of the market itself was scaring investors. Even companies not facing financial problems are at risk of default on their commercial paper if they are not able secure another round of financing to pay off their paper that had matured
NEW YORK (CNNMoney.com) -- The market for commercial paper, a key form of lending to major businesses and banks, continued to shrink in the past week, according to a report from the Federal Reserve Thursday.
The latest figures released Thursday morning show total commercial paper outstanding fell by $56.4 billion, or 3.5%, in just the past week, to $1.55 trillion.
The decline marks the fourth straight week of declines, a fall that has reduced total commercial paper outstanding by $264.4 billion, or 15%, as the credit crisis escalated on Wall Street.
"What that tells you is that corporations that have generally been able to borrow in that market have been frozen out," said Lyle Gramley, a former Fed governor now serving as an economist with the Stanford Group.
Commercial paper is sold by major corporations and most of the nation's leading financial institutions. They use the proceeds to fund day-to-day business operations. It is bought primarily by money market fund managers and other institutional investors.
"It's basically the checking accounting for business," said Kevin Giddis, head of fixed-income sales trading and research for investment firm Morgan Keegan. "It is literally how they operate on a day-to-day cash basis. It's their main funding source."
The sharp drop in commercial lending in recent weeks prompted the Fed to announce an unprecedented program to have the central bank start to buy the paper, a move that essentially will have the Fed lending money directly to many major companies.
Many details of the Fed's plans are still being worked out. Fed officials who briefed reporters on the program Tuesday said they hoped just the announcement of the Fed's plans to buy commercial paper would assure investors to return to that market knowing that the central bank would soon be a backstop.
Gramley said he's hopeful that the Fed's commercial paper program will start to solve the problem soon, but that it didn't have enough time to have any meaningful impact on this latest reading.
"I would say probably by next week's numbers, things will be beginning to settle down," he said.
For investors, commercial paper was considered a very safe investment to purchase, even if most of it was backed by little more than the company's and banks good reputation. The strength of the firms selling the paper meant it could be easily resold.
But since the bankruptcy of Lehman on Sept. 15, many leading buyers of commercial paper have been afraid to play in the market, shifting their investments to safer U.S. Treasurys instead. No one wanted to get caught holding commercial paper for a company or financial institution that suddenly found itself in trouble.
And the seize-up of the market itself was scaring investors. Even companies not facing financial problems are at risk of default on their commercial paper if they are not able secure another round of financing to pay off their paper that had matured
Bull vs. Bear: Looking for bottom
Stocks went on another wild ride Friday. But after nearly two weeks of selling, is the bottom finally near? Bulls and bears sound off.
By Paul R. La Monica, CNNMoney.com editor at large
Last Updated: October 10, 2008: 4:23 PM ET
NEW YORK (CNNMoney.com) -- Is it safe? Forgive the "Marathon Man" reference, but the past few weeks have certainly been the financial equivalent of Dustin Hoffman getting tortured by the sadistic dentist.
The Dow has plummeted 25% since Sept. 26 and 17% this week alone.
That does not even include the action on Friday: The Dow plunged nearly 700 points in the first few minutes of trading, recovered most of those losses within 45 minutes, fell more than 550 points again later in the day, went on a monstrous rally in the last hour and at one point was up more than 300 points before finally pulling back again and finishing down more than 100 points. Whew.
So, again, as the dentist asks, "Is it safe?"
In other words, are we finally nearing "capitulation," that fancy word that Wall Street types use to describe what happens once people get all the panic selling out of their system and start buying?
Talkback: When will the stock market bottom out?
It's almost impossible to tell. Many have tried to call a bottom in the past few weeks and months (and I will take full responsibility for unfortunately being one of them) and have clearly gotten that call wrong.
But let's try to answer it yet again, with insights from market experts I respect and trust.
Stocks went on another wild ride Friday. But after nearly two weeks of selling, is the bottom finally near? Bulls and bears sound off.
By Paul R. La Monica, CNNMoney.com editor at large
Last Updated: October 10, 2008: 4:23 PM ET
NEW YORK (CNNMoney.com) -- Is it safe? Forgive the "Marathon Man" reference, but the past few weeks have certainly been the financial equivalent of Dustin Hoffman getting tortured by the sadistic dentist.
The Dow has plummeted 25% since Sept. 26 and 17% this week alone.
That does not even include the action on Friday: The Dow plunged nearly 700 points in the first few minutes of trading, recovered most of those losses within 45 minutes, fell more than 550 points again later in the day, went on a monstrous rally in the last hour and at one point was up more than 300 points before finally pulling back again and finishing down more than 100 points. Whew.
So, again, as the dentist asks, "Is it safe?"
In other words, are we finally nearing "capitulation," that fancy word that Wall Street types use to describe what happens once people get all the panic selling out of their system and start buying?
Talkback: When will the stock market bottom out?
It's almost impossible to tell. Many have tried to call a bottom in the past few weeks and months (and I will take full responsibility for unfortunately being one of them) and have clearly gotten that call wrong.
But let's try to answer it yet again, with insights from market experts I respect and trust.
The bear case
The bear case
Barry Ritholtz, CEO of research firm Fusion IQ, wrote in a note to clients yesterday afternoon - before the Dow experienced its huge swoon in the last half-hour - that if the Dow failed to stay above 8,750 that would be very bad news.
Unfortunately, the Dow closed yesterday at 8,579.
With that in mind, Ritholtz suggested that the next support level for the Dow could be the low from the last bear market in 2002...about 7,250.
Another money manager agreed that there could be more downside.
"I'm not so bold to say that this is capitulation. At this point, what you're seeing is that the market is driven by hearsay and fear and it feeds on itself," said Jeff Buetow, managing director at Portfolio Management Consultants, the investment consulting unit of Chicago-based asset management firm Envestnet, which has $90 billion in assets.
Buetow said he thinks the S&P 500 could hit 800, about 10% lower than current levels He said that the markets will remain extremely volatile until the housing market recovers.
Haag Sherman, managing director of Salient Partners, an investment firm based in Houston, said that there is no reason to expect the U.S. and global stock markets to recover until the credit markets thaw first.
He explained that the spread between 3-month U.S. Treasurys and the 3-month London interbank offered rate, or Libor, is so wide that it is showing that the credit markets are in "cardiac arrest."
The 3-month Libor rate, which is perhaps the most important indicator of how much banks are charging each other for loans, hit 4.82% Friday morning while the yield on the 3-month Treasury was just 0.4%. Typically, there is less than a percentage point difference between these two rates, Sherman said.
And with the spread this high, that means banks are showing they are unwilling to take on the risk of lending to each other as well as many businesses and consumers.
"The credit markets have to stabilize before global equity markets will stabilize. Until that happens, you will continue to see a selloff in stocks. And the first sign of recovery will be seen with Libor," Sherman said.
Not everyone is so pessimistic though.
The bear case
Barry Ritholtz, CEO of research firm Fusion IQ, wrote in a note to clients yesterday afternoon - before the Dow experienced its huge swoon in the last half-hour - that if the Dow failed to stay above 8,750 that would be very bad news.
Unfortunately, the Dow closed yesterday at 8,579.
With that in mind, Ritholtz suggested that the next support level for the Dow could be the low from the last bear market in 2002...about 7,250.
Another money manager agreed that there could be more downside.
"I'm not so bold to say that this is capitulation. At this point, what you're seeing is that the market is driven by hearsay and fear and it feeds on itself," said Jeff Buetow, managing director at Portfolio Management Consultants, the investment consulting unit of Chicago-based asset management firm Envestnet, which has $90 billion in assets.
Buetow said he thinks the S&P 500 could hit 800, about 10% lower than current levels He said that the markets will remain extremely volatile until the housing market recovers.
Haag Sherman, managing director of Salient Partners, an investment firm based in Houston, said that there is no reason to expect the U.S. and global stock markets to recover until the credit markets thaw first.
He explained that the spread between 3-month U.S. Treasurys and the 3-month London interbank offered rate, or Libor, is so wide that it is showing that the credit markets are in "cardiac arrest."
The 3-month Libor rate, which is perhaps the most important indicator of how much banks are charging each other for loans, hit 4.82% Friday morning while the yield on the 3-month Treasury was just 0.4%. Typically, there is less than a percentage point difference between these two rates, Sherman said.
And with the spread this high, that means banks are showing they are unwilling to take on the risk of lending to each other as well as many businesses and consumers.
"The credit markets have to stabilize before global equity markets will stabilize. Until that happens, you will continue to see a selloff in stocks. And the first sign of recovery will be seen with Libor," Sherman said.
Not everyone is so pessimistic though.
The bull case
The bull case
Daniel Alpert, managing director with investment bank Westwood Capital, used one C word (capitulation) as well as another (crash) to describe what's going on in the markets. He suggested it might be time to tentatively wade back into stocks.
"By any measure, we are now at the point of capitulation. This is the house cleaning that the market has been procrastinating over for a year," Alpert wrote. "The fundamentals underlying the delayed and extended crash are the same as they were a year ago, even two years ago."
Clearly, the markets are not going to go to zero - even though there seem to be a lot of readers of this column that feel that way. At some point, investors will have to recognize that there are stocks out there that have been unfairly punished and are dirt-cheap bargains.
In fact, it's harder and harder by the day to argue that the market as a whole is overvalued. The S&P 500 is trading at just 9.5 times 2009 earnings estimates.
Francois Sicart, chairman of Tocqueville Asset Management, investment firm with about $6 billion in assets, said he thinks the markets are "right in the middle of capitulation."
Once fear begins to subside, he thinks investors will flock back to big companies with relatively healthy businesses that look attractive.
"This is totally characteristic of an overly emotional reaction," Sicart said. "Valuations are looking pretty good for big companies like GE, 3M and DuPont. There are times in the market where you can buy some of the best companies at extremely decent prices."
Wasif Latif, assistant vice president of equity investments for USAA Investment Management Co. in San Antonio, which has about $41 billion in assets, agreed that this is a good time for investors that can afford to be patient to start hunting for bargains.
"Someone with a longer-term approach should be taking advantage of this and nibbling away at these declines," he said."If you have some additional gunpowder left in terms of cash, then it is a good tactic to look at some quality companies and buy them."
But Latif conceded that as long as investors are fearful, valuations may not matter in the short-term.
"This is not a Benjamin Graham market," Latif said, referring to the father of value investing. "This is a Sigmund Freud market."
The bull case
Daniel Alpert, managing director with investment bank Westwood Capital, used one C word (capitulation) as well as another (crash) to describe what's going on in the markets. He suggested it might be time to tentatively wade back into stocks.
"By any measure, we are now at the point of capitulation. This is the house cleaning that the market has been procrastinating over for a year," Alpert wrote. "The fundamentals underlying the delayed and extended crash are the same as they were a year ago, even two years ago."
Clearly, the markets are not going to go to zero - even though there seem to be a lot of readers of this column that feel that way. At some point, investors will have to recognize that there are stocks out there that have been unfairly punished and are dirt-cheap bargains.
In fact, it's harder and harder by the day to argue that the market as a whole is overvalued. The S&P 500 is trading at just 9.5 times 2009 earnings estimates.
Francois Sicart, chairman of Tocqueville Asset Management, investment firm with about $6 billion in assets, said he thinks the markets are "right in the middle of capitulation."
Once fear begins to subside, he thinks investors will flock back to big companies with relatively healthy businesses that look attractive.
"This is totally characteristic of an overly emotional reaction," Sicart said. "Valuations are looking pretty good for big companies like GE, 3M and DuPont. There are times in the market where you can buy some of the best companies at extremely decent prices."
Wasif Latif, assistant vice president of equity investments for USAA Investment Management Co. in San Antonio, which has about $41 billion in assets, agreed that this is a good time for investors that can afford to be patient to start hunting for bargains.
"Someone with a longer-term approach should be taking advantage of this and nibbling away at these declines," he said."If you have some additional gunpowder left in terms of cash, then it is a good tactic to look at some quality companies and buy them."
But Latif conceded that as long as investors are fearful, valuations may not matter in the short-term.
"This is not a Benjamin Graham market," Latif said, referring to the father of value investing. "This is a Sigmund Freud market."
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