January 8, 2008
Elaine Meinel Supkis
Gross of PIMCO claims credit default swaps will swamp banks with $250 billion in losses. This absurd amount is based on one tenth this size in loans. The act of hedging is creating a monster 10X bigger! The philosophy of hedging which was to reduce risk, increases and spreads the risks to everyone, everywhere. Stocks fell badly today and it looks like the banks who bought Countrywide stocks are being hosed as it drops from $28 a share last October to under $6 a share. And it is time to remember when the housing boom's end really began: with Hurricane Katrina.
Credit Derivatives May Lose $250 Billion, Gross Says
Credit-default swaps, used to help protect against the risk a company won't pay its debt, may cause losses of $250 billion this year, helping send the U.S. economy into a recession as corporate defaults rise, Pacific Investment Management Co.'s Bill Gross said.``Credit-default swaps are perhaps the most egregious offenders'' in today's banking system, Gross wrote on the company's Web site today. ``Our modern shadow banking system craftily dodges the reserve requirements of traditional institutions and promotes a chain letter, pyramid scheme of leverage, based in many cases on no reserve cushion whatsoever.''
No reserves, eh? I harp about this little matter. It sits right next to the 'no savings' mantra. We, as a nation and as a culture, have neither reserves nor savings. This is due to us having lots and lots of 'credit' which means, 'loans'. I am very certain that the 0% interest savings, 0% interest loans, carry trade funny money paradigm we are presently in is rapidly destroying future wealth. Time is money! And if we run around playing these silly games today, we pay for it all tomorrow. We think we will never need any reserves of any sort at any level just like we mock sovereign wealth or the entire idea of savings at all, we do this while hoping we can create instruments that generate wealth even as the deny the possibility of shrinkage.
Try running a store that pays no attention to shrinkage! Like shoplifting or damage to goods or economic downturns slowing inventory sales! When the Asian Currency Crisis happened, we told all the Asians that they needed good reserves to protect their finances. Yet we have the most ridiculously low reserves on earth! As American financial groups generated a mass of loans, there was no authority demanding they raise their reserves to cover these loans. The riskier the loans, the more they needed reserves in case of default! But of course, this wasn't done because the main banking houses were farming out these loans to offshore entities.
Mr. Gross is correct that these entities with no reserves are up to their chins in potential defaults to the tune of a quarter trillion. This is less than Russia's FOREX reserves which is mostly gold [and oil]. Germany, the world's #4 industrialized nation, has reserves of $131 billion. France's reserves is $120 billion. That equals the BAD money we might see vanish in this latest magic act.
Time to remind ourselves what a credit default swap is:
is a bilateral contract under which two counterparties agree to isolate and separately trade the credit risk of at least one third-party reference entity. Under a credit default swap agreement, a protection buyer pays a periodic fee to a protection seller in exchange for a contingent payment by the seller upon a credit event (such as a default or failure to pay) happening in the reference entity. When a credit event is triggered, the protection seller either takes delivery of the defaulted bond for the par value (physical settlement) or pays the protection buyer the difference between the par value and recovery value of the bond (cash settlement).Credit default swaps resemble an insurance policy, as they can be used by debt owners to hedge against credit events. However, because there is no requirement to actually hold any asset or suffer a loss, credit default swaps can be used to speculate on changes in credit spread.
Credit default swaps are the most widely traded credit derivative product[1]. The typical term of a credit default swap contract is five years, although being an over-the-counter derivative, credit default swaps of almost any maturity can be traded.
At every step, the people who create loans are removing themselves from the responsibility of making up the difference if the loan fails. There should always be an element of fear on the part of the people handing out loans. Without this fear, they end up giving loans to all and sundry, nonstop. This causes everything to balloon and collapse so over the centuries, wise governors have forced lenders to hold the hazards. The mere act of passing a debt from one person to another breeds fiscal irresponsibility. This is based on the medieval concept of fiefs: the lord holding title to the land would hand it over to someone in lieu of service. They, in turn, must support their lord. These lands were mixed and matched by marriage and grants to the point, kings were in fief to other kings such as Henry II was to the King of France in the late 1100's. This caused various wars for....ummmm....500 years! One of these wars was dubbed, 'The Hundred Year's War.'
For much of our nation's history, banks had to hold the mortgages and loans they granted. If we look at our money, it says it is for paying off loans. Period. The dollar represents debt and is used to pay debts. The elaborate bookkeeping systems set up over the last 500 years, ever since fiefdom died...actually, one of my ancestors got a slice of Ireland as his fief...he had to kill a number of irritated Irish who were shocked when he showed up...the modern bookkeeping set up to stabilize the lending system while letting banks be creative about cranking out loans and thus, creating money, has collapsed periodically. This happens when lenders get reckless while at the same time, people can't pay off previous promises due to too many entities carrying too much debt. Bank runs would then begin as people try to withdraw money and discover the RESERVES are not there!
The reason we have laws or customs about reserves is due exactly to this problem. If only 11% of a bank's funds are withdrawn suddenly, they collapse. Generally, this doesn't happen. But when there is currency devaluations or bankruptcies, these runs have and did happen, even recently in England. England, the land that wants to be the world's bankers has virtually no reserves at any level. Snort. Right!
Hedging was hatched by people who want to have their cake and eat it too. They need to be able to make loans and then disown these loans. Sending the risk outwards meant multiplying the risks. These then move out like ripples when a stone is cast into water. Everyone is happy since no one is responsible for anything. We see this today as courts ask the lenders to show paperwork and there is a total muddle as to who owns what.
The market for credit derivatives is now so large, in many instances the amount of credit derivatives outstanding for an individual name are vastly greater than the bonds outstanding. For instance, company X may have $1 billion of outstanding debt and $10 billion of CDS contracts outstanding. If such a company were to default, and recovery is 40 cents on the dollar, then the loss to investors holding the bonds would be $600 million. However the loss to credit default swap sellers would be $6 billion. In addition to spreading risk, credit derivatives, in this case, also amplify it considerably.Another major issue is the vast difference in knowledge concerning the creditworthiness of the underlying borrower. Major banks and investment banks, like JP Morgan Chase, Citigroup, Bank of America, Merrill Lynch, Goldman Sachs, Lehman Brothers, etc., are usually the originators of syndicated loans or the underwriters of stock and bonds of the companies in question. Credit swaps are issued, by these same banks, against the credit of those companies. JP Morgan and its cousins have a much better idea whether or not particular borrowers are really at risk of default, because of their relationships with those borrowers. This can be deemed "inside" information, which would be illegal to possess while actively trading in a particular market, in almost any other field of market activity. Yet, within the credit default swap trading community, insider trading is not only a given, but is the fundamental basis upon which the entire structure depends. Indeed, these same major banking institutions also dominate the market for issuance of derivatives, generally.
Insider trading is inherent within the system. This is why the rich love it so much. They are the system itself. They set the rules, the terms and they know more than anyone else. Goldman Sachs cynically sold things to others while betting these same things were bad things. Poison. Deadly. But they told their victims, the things were great and would create wealth, not kill them. According to Gross, these CDS deals for $25 billion are going to cause $250 billion to vanish into thin air. And we can now understand why the central bankers were frantic to put up nearly a trillion dollars in rescue funds. This mess is still undigested. Even if the central banks can lend this much loot, it doesn't fix the underlying problem of reckless loans going sour and thus, triggering avalanches of multiple deals based on these bad loans!
I say, outlaw hedging and selling off of loans! Sometimes, curtailing a process is the only thing we can do. For example, at Markit.com, "The Markit ECMBX Index is scheduled for a first quarter launch and will consist of four sub indices: one Sterling-AAA, one Sterling-BBB, one Euro-AAA, and one Euro-BBB.
The indices will each consist of 20 single name PAYG CDS referencing eligible European CMBS bonds and are expected to roll on a semi-annual basis. Constituents will be selected according to a defined set of rules."---they are setting up yet another CDS game! And this one is based in Europe, as if Europe isn't sliding off the same dangerous slope the US has slid off!
A group of indexes made up of 25 tranches of commercial mortgage-backed securities (CMBS), each with different credit ratings. The CMBX indexes are the first attempt at letting participants trade risks that closely resemble the current credit health of the commercial mortgage market by investing in credit default swaps, which put specific interest rate spreads on each risk class. The pricing is based on the spreads themselves rather than on a pricing mechanism.Daily trading involves cash settlements between the two parties to any transaction, and the CMBX indexes are rolled over every six months to bring in new securities and continuously reflect the current health of the commercial mortgage markets. This "pay as you go" settlement process considers three events in the underlying securities as "credit events": principal writedowns, principal shortfalls (failures to pay on an underlying mortgage) and interest shortfalls (when current cash flows pay less than the CMBX coupon).
CMBX indexes are yet another scheme to evade responsibility and this is more akin to betting on the Super Bowl, what with all the talk about 'spreads' which is pure gambling talk. From the 1600's to today, investing intersects with gambling and playing the odds. This leads to manias and recklessness. Commercial mortgage markets go down in bad times and causing total financial chaos by multiplying the amounts of money being played with, all hinging on the possibility of collapse, is so recklessly irresponsible! I can't believe governments refuse to govern this sort of thing! It happens to be something they should be guarding us from. But then, look at outright gambling. It is called an 'industry' and is spreading like wildfire and is as destructive as wild fires. It kills savings.
Stocks fell today due to Countrywide, a very reckless lending company, is probably on its last legs.
This looks nearly as bad as the Nikkei. When a consortium of bankers bought up the decrepit Countrywide stocks back last October at $28, I thought they were nuts. Now, the stock is at $6 a share and dropping rapidly. More vanishing billions here. Even as these same banks and financial houses push away responsibility for their loans, they buy stocks and hold them or sell them and thus, gain or lose money the old fashioned way. Nationwide denies they are going bankrupt but they can't even buy a hamburger and pay it back on Tuesday. End of the road for them and they leave behind a monumental mess that has been greatly augmented by their goofy hedging schemes.
By the way, last fall, Misch had some funny things to say about Gross, the Wise Man of this story.
PIMCO's Bill Gross was asking Where’s Waldo? in his investment outlook for September 2007.
I see the top bond guru in the world returned a three year average of 3.83% in his "Total Return" Fund. One could have parked money in a money market fund, CDs, a bank, or short term treasuries and done better than that.Digging deeper I see the top five holdings of the Total Return Fund are as follows.
1) Fannie Mae
2) Fannie Mae
3) Fannie Mae
4) Fannie Mae
5) Fannie Mae
As far as I can tell, many of the funds crowing about making money did this by either betting on gold and oil futures, after all, they are the ones driving up these things, or hedging like crazy. Frankly, most funds make minimal amounts and charge an arm and a leg for this. Speaking of gold, it hit a new high today. A reader sent me an email saying it reached $888 an ounce on the 8th of the month at 8 minutes after the hour. INFINITY AT LAST! How happy is that? Obviously, a host of people are piling into the gold markets because the CMBX markets are a fool's errand. It is interesting to see people run for physical substances as things deteriorate. Paper deals can drop to $0 in a flash. Literally, if there is a fire.
Gold has great durability like diamonds. It doesn't go bad. It is very physical. But like real estate, it can lose value rapidly. Cigarettes were more valuable than gold if there is a war. And gold buys precious little bread if there is a famine. On the other hand, if people running our finances plan to create 0% loans, gold will be $2,000 an ounce, easily. And a $50,000 house will be $500,000. Indeed, this happened already. Gold is merely catching up.
Incidentally, Gross called the end of the housing bubble at a most interesting time:
Pimco's Gross: End of bubble is nigh
Go short and avoid real estate, equities, corporates
Sept. 6, 2005WASHINGTON (MarketWatch) - Investors should prepare themselves now for the end of the U.S. housing bubble by avoiding assets like equities, real estate, corporate debt and junk bonds, said Bill Gross, managing director of Pacific Investment Management Co.
In his monthly investment outlook, Gross advised investors to "cut the fat" from their portfolios.
Gross, a well-regarded bond bull, said the housing bubble is likely to either stop inflating, deflate or pop within the next few months, leading to a slowdown in economic growth. Read his commentary.
Pimco is the largest bond fund manager in the United States, with $493.3 billion in assets under management.If the bubble ends, investors must prepare for the "debt liquidation" that Federal Reserve Chairman Alan Greenspan warned about 10 days ago, Gross wrote.
He looks like he is a good seer only this story's date gave me a jolt. Greenspan, as I recall, made some dire warnings about housing right when a massive catagory 5 hurricane was slamming into a major city, nearly totally destroying it. It was obvious during the hurricane and afterwards, our government was bankrupt, morally and financially. Thousands of Americans died and there was virtually no help for them and to this day, little help. Time to look at what I wrote when Gross was worried about a mere financial crisis that was totally man-made or I should say, Greenspan-made.
I repeat: FEMA Director Michael Brown didn't know the situation at the Super Bowl until THURSDAY. Readers of the news and this blog knew about it since Sunday. The host of Marie Antoinettes who spent the last two years snoozing at their desks in DC are a troop of Sleeping Boobies who just got kissed by a frog and woke up.I want these people arrested. They are a hazard to life and limb. I would happily make a citizen's arrest: "Depraved indifference". He is guilty of child abuse, murder and refusal to prevent a crime.
Brown's memo told employees that among their duties, they would be expected to "convey a positive image of disaster operations to government officials, community organizations and the general public."Everything with the Bush bureaurocracy is about appearances. Smoke and mirrors. All papered over, glossy surface hiding defective goods, shoddy work, broken promises. It is all photo ops without any operative parts, the ultimate Potemkin President.
This mental illness pervades DC. All they care about is how they are preened by the press and how people view them. Substanceless and ghastly, they are like an old whore with a painted face.
"FEMA response and recovery operations are a top priority of the department and as we know, one of yours," Brown wrote Chertoff. He proposed sending 1,000 Homeland Security Department employees within 48 hours and 2,000 within seven days.See? The plan was all along to send in as few people as possible. Enough to make it look as if DC had some interest in seeing things done but not enough to do much of anything. And then, after dwadling for two days, send in a pitiful few more a week later? Insane!
Knocke said the 48-hour period suggested for the Homeland employees was to ensure they had adequate training. "They were training to help the life-savers," Knocke said.Employees required a supervisor's approval and at least 24 hours of disaster training in Maryland, Florida or Georgia. "You must be physically able to work in a disaster area without refrigeration for medications and have the ability to work in the outdoors all day," Brown wrote.
Huh? Whiile people are drowning, they are going to give swimming lessons? What planet do they...oh, Mars.
The same day Brown wrote Chertoff, Brown also urged local fire and rescue departments outside Louisiana, Alabama and Mississippi not to send trucks or emergency workers into disaster areas without an explicit request for help from state or local governments. Brown said it was vital to coordinate fire and rescue efforts.Not only did they force people to wait, FEMA spent most of their feeble energy preventing any rescues. The idea that no one can "ask" when there are no telephones or radios or anything...well, this is the Potemkin Bush team. Phantoms of the Operatives.
By MONDAY, the airport was functionable! FEMA and Homeland Security (sic) have laws in place allowing the President to activate the airlines and impress them into service in an emergency! It wasn't even thought of until THURSDAY and only after many people on the blogs and elsewhere screamed themselves hoarse (I included) trying to force these clowns into activating this law!
All systems are being hedged and all are malfunctioning badly. The housing crisis definitely started with this hurricane. Just like the bubble began with the destruction of the biggest office complex in America, on 9/11. We just saw the US trying to turn a silly aquatic confrontation with some tiny speedboats in the Persian Gulf into a causus bellus. This will send the price of oil soaring again. And note how the war in Iraq, triggered by a misplaced belief that Saddam, who hates Bin Laden, caused 9/11, caused world oil to soar in price. And then Hurricane Katrina slammed into our oil wells and this made things much worse and now this?
All the hedges in the world can't stop the collapse of global economies if the price of energy shoots up. And all the masses of financial wizards are frantically moving their funds into oil and gold in the hopes of staying rich even as this simply dooms their other enterprises.
Culture of Life News Main Page
We just saw the US trying to turn a silly aquatic confrontation with some tiny speedboats in the Persian Gulf into a causus bellus.
LOL GULF OF TONKIN 2!!!!
WTC 7 "Just Pull It"
Posted by: Greg | January 09, 2008 at 12:08 AM
Elaine,
Check out this graph of us bank reserves based on data from the fed. It shows a huge infusion of reserves just after 911...to be expected.
But to the right there is a huge withdrawal of reserves about 30 days go!!
Why?...notice the graph goes way back to 1960 and this event seems unprecedented.
What does this graph mean?
http://research.stlouisfed.org/fred2/
series/NFORBRES?cid=123
Posted by: mock turtle | January 09, 2008 at 02:02 AM
They pulled the page, Mock Turtle. I will try to dig it up, I track this periodically. It has been several weeks since I went off to see what is actually going on.
Posted by: Elaine Supkis | January 09, 2008 at 11:31 AM
http://research.stlouisfed.org/fred2/fredgraph?chart_type=line&s[1][id]=NFORBRES&s[1][range]=10yrs
It's still there, but this comment box adds carriage returns to links for some odd reason.
Posted by: CK | January 09, 2008 at 11:48 AM
I got it! Thanks! Wow.
Posted by: Elaine Supkis | January 09, 2008 at 01:46 PM
Are they burning through their reserves to stay solvent (or at least to avoid having to admit their insolvent)? If so, what happens when the reserves are gone?
Very interesting chart.
Posted by: shargash | January 09, 2008 at 02:14 PM
I redesigned the chart. WOW. heh. Will publish it and the analysis soon.
Posted by: Elaine Supkis | January 09, 2008 at 04:19 PM
Elaine: thanks for your terrific post on Credit Default Swaps and the ABX-HE indexes. A few important pieces of infomation to consider-
Point 1)They(ABX CDS)settle in cash. This is unfortunate because the consortium of 16 also control the pricing mechanisim. This eans that a naked short position of 5 to one (exisiting contracts to available legitimate collateral) and the settlors just pay the cash differens of the index price versus par. There is no "short squeeze" potential a la the bankrupt Delphi bonds. (in Delphi, the Wall steet firms took in the premiums on the default insurance on many times more bonds than actually existed- this caused a meltdown in the CDS market, as it should have!)
Point 2: Goldman's Brad Levy was the Chairman of CDS Indexco the organization that dreamed up the ABX index and all the trading rules, membership criteria, conventions etc. Then we come to find out that Goldman obviously must have used that position of intellegence to gain advantage. (see Bloomberg Article- Jan 14)
http://www.bloomberg.com/apps/news?pid=20601087&sid=aDApw2n5n2M8&refer=home
Lastly, the accounting rule that was scheduled to go into effect on Nov. 15th FAS 157, accounting for fair value of securities when there are no active markets- thrust the ABX back into the limelight. And "co-incidentally", on that date- CDS Indexco was meged into MarkIt the distributor of the information prepared by CDS Indexco. This act put Goldman Sachs right at the apex of the entire mispricing mess. A look into the pricing mechanisim of the structured finance products on the books of banks, mutual funds, thrifts, money managers, hedge funds etc, will reveal that they must classify their unpricable assets (according to FAS 157) as Tier III assets, and thus they must find a market of securities that resembels, even if only slightly, the market they feel would be most close to the one their securities would enjoy IF there were such a market. (remember we're talking about hypothetical markets). Guess what the only market available for these erstwhile investors is- you guessed it- the Goldman ABX-HE.
BTW - the appearace of an active market has been given to the ABX, but with SEC looking into Goldie, it's anyones guess as to how it will all shake out. Since nothing is trading in the OTC market for structured finance bonds, does it really matter.
I dont see how you should be able to naked short an insurance contract. It would seem to me that the state insuranc ecommissioners would look at this an say " why you have no insurable interest in these bonds" And thats's against the law!
Posted by: tommy two tone | January 14, 2008 at 11:25 PM
Sure, there are debt settlement law firms out there, and
some of them are very good at what they do. However, some of these firms
charge 25% or more of the enrolled debt. Many, if not most, consumers
simply canТt afford to pay fees of this magnitude. Also, being an
attorney in one state does not offer any special protection to a
consumer in another state where that attorney is not licensed. ItТs
simply not necessary to hire an attorney to settle your debts. Most
consumers can handle it on their own with a little training and
coaching.
debt negotiation and settlement
Posted by: debtsettlement | January 16, 2008 at 05:26 PM
Thanks for all the inside information, Tommy two tones! I have been fiddling with the MarkIt site since its inception. Often, mocking it when things fell through. It is a funny place, much laughs for me. I remember when they thought the numbers would go UP!
Never, down! Goldman Sachs, I have been eyeballing for years. Their need to be in control means the are by definition, INSIDE TRADERS which means CON MEN.
So I issue warnings about them. Alas, short selling them doesn't work. They control many levers of power and are hard at work, destroying our economic base.
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