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I Have Seen the Enemy, and He is CDS

Fri, Sep 19 2008, 14:21 GMT
by Mike Larson

Money and Markets

It's been quite the eventful week on the bailout front, eh?

The Treasury and Federal Reserve drew the line at Lehman Brothers, allowing the fourth-largest broker in the U.S. to file for bankruptcy.

Then a couple days later, the Fed backtracked and arranged an $85 billion bailout of American International Group. The deal gives AIG a two-year loan at a punitive interest rate of 11.5%, and grants the Fed a 79.9% stake in the insurance firm. The idea is to keep AIG afloat while it sells assets to raise money.

Personally, this is just more evidence that no one seems to know how deep this rabbit hole of losses goes. Every time one troubled financial institution gets saved or fails, another troubled one pops up somewhere else.

As I've been discussing for a long time, crummy residential mortgages ... troubled commercial mortgages ... and all kinds of other souring loans are causing a huge chunk of the problems in the banking and brokerage industry. But in the case of AIG, something else is at work. It's an obscure kind of contract that, behind the scenes, is wreaking havoc throughout the financial industry.

And I want to talk about these "CDS" — or Credit Default Swaps — today.

How Credit Insurance Works

I'm sure you know how traditional insurance works. After all, you have some combination of homeowners insurance, life insurance, auto insurance, and maybe even a policy on an RV, a boat, or a motorcycle.

You pay a monthly, semi-annual, or annual premium to an insurance company. And the company invests that money to generate returns. If a catastrophe strikes — you get in a car crash, your house burns down, or you die — the insurance company pays you or your heirs a lump sum of money.

It's a pretty straightforward business.

But in the past few years, many Wall Street firms, hedge funds, and companies like AIG plunged headlong into the Wild West World of CDS.

CDS operate like insurance on a bond or other security. Let's say you're a portfolio manager who owns $100 million in XYZ Corp. bonds. You read the paper, and you see that the industry XYZ is in is faltering, with sales declining and profits falling.

As a result, you might be concerned about the possibility that XYZ will default on the bonds you're holding. But for one reason or another, you don't want to sell your bonds and move on. So instead, you go into the market and buy CDS to protect you against the possibility of default.

You — the credit protection buyer — would pay periodic premiums (just like you and I do on life or car insurance) to a credit protection seller. If XYZ does NOT default, then the seller just collects his premiums and makes a decent return. If XYZ does default, then the seller either takes the bonds off your hands, paying you face value (regardless of where they're trading), or he pays you a cash settlement that makes you whole.

Either way, you as the buyer are protected from catastrophic loss — just like a homeowner is protected from catastrophe by his policy when his home burns down.

The Flaws in the System

Sounds good, right? But here are the problems ...

First, CDS aren't highly regulated like the traditional insurance market is at the state level. In fact, the CDS market isn't really regulated at all. As we alerted our Safe Money Report readers way back in a November 2006 gala issue on derivatives ...

"Complacency is now unprecedented and regulators are asleep at the switch. The Securities and Exchange Commission says it has no direct supervision of trading in credit derivatives. The Commodity Futures Trading Commission also says it isn't responsible. The International Swaps and Derivatives Association (ISDA) says the industry can policy itself. We're not so sure."

Second, the CDS market exploded in size over the past several years. According to the British Bankers Association, the CDS market expanded from just $180 billion in 1996 to a stunning $20 trillion a decade later. That's a 111-fold expansion in this esoteric, opaque market. And by all accounts, it continued to grow LAST year as well — to a whopping $57.9 TRILLION, according to the Bank for International Settlements.

Third, the CDS market morphed into a vehicle for massive speculation on corporate credit rather than a way to hedge downside risk. Investors started buying CDS on companies with worsening credit — expecting those contracts to rise in value — and selling CDS on companies with improving credit — expecting to record a gain as those contracts declined in value.

Fourth, the quality of counterparties in the CDS market deteriorated substantially. What do I mean? When you bought your last homeowners or life insurance policy, you probably checked the credit rating of the company selling that policy. After all, what good is insurance if the company standing behind it can't make good on claims?

The problem is that more and more CDS were being bought and sold by hedge funds and other thinly capitalized companies during the boom days. This excerpt from a recent Minyanville column pretty much sums up the problem:

"A hedge fund trader once told me that they insured/sold 50 times their capital in CDS with the counterparty being a very large, well-known investment bank.

"When I asked him if he was worried about that kind of leverage, he responded by saying that is the bank's problem because if he is wrong about writing all these insurance policies (in the form of CDS), they can only lose their investment capital in the fund."

Comforting, eh?

The Fallout is Spreading

So how does AIG fit into all this?

Well, it sold protection on a mind-boggling $441 billion of fixed income securities. $441 billion! According to Bloomberg, almost $58 billion of those contracts referenced securities tied to subprime mortgages. That's what really brought AIG to its knees — the exposure to the CDS market.

Who else has massive exposure to credit derivatives?

According to a Fitch Ratings report from last year, the top five counterparties on CDS contracts (as of 2006) were:

• * Morgan Stanley,
• * Goldman Sachs,
• * JPMorgan Chase,
• * Deutsche Bank, and
• * ABN Amro.

It's impossible to know exactly how these institutions are positioned, how those rankings have changed since then, and so on. What we do know is that this garbage paper is spread throughout the system, that the underlying securities that CDS insure are plunging in value, and that the financial tally from this whole mess is rising month in and month out.

If you needed yet ANOTHER reason to remain skeptical of the financial industry's fortunes, the CDS market is it. Stay safe!

Published on  Fri, Sep 19 2008, 14:25 GMT