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Credit Default Swaps
How credit derivatives are what might destroy the world economy
© Bryan Zepp Jamieson
http://www.mytown.ca/zepp
7/20/08
Back in the 90s, when libertarians swaggered around the web, explaining that
the Ayn Rand philosophy that society should be a dogfight favored the best and
the brightest. It was just coincidental that they happened to be those with the
most money, and thus government should leave “the free market” alone to make
sure that the deserving prospered and the undeserving, um, didn’t.
Asked about the increasing disparity between the haves and the have-nots, and
especially the huge one growing between the people who produced the goods and
those who manipulated the investments surrounding such endeavors, libertarians
would smugly assured us that they got so much more money because they were the
leaders, the doers, the captains of industry, the risk-takers. If some noble,
selfless sort was to put out millions to make our jobs possible, then there had
to be incentive in there for the risk-taker. This would usually be followed by
the jibe that no poor person ever created a job. Followed by a stony silence
when it was pointed out that without the poor people, there wasn’t going to be
any way the risk-takers could make money.
I always figured the “risk-taking” was mostly a load of bullshit. With the
market as unregulated as it was, the “risk-takers” were going to make damned
sure their butts were covered. There really isn’t any reason why someone who was
already set for life was going to put billions of dollars into a startup without
making sure that if everything went pear-shaped, his potential losses were
minimized. Some even rigged it, “Producers”-style, so they would make money if
the enterprise failed.
Pure capitalism at its finest. Ah, you can smell the fear and greed on the air!
An ideal investment is one that brings back huge amounts of money on very little
outlay, and involves little or no effort, and no risk. Compared to people who
work 60 hours a week to keep up on the rent, that certainly seems fair, doesn’t
it?
They also prefer that it be unregulated. Oh, they know that a Republican
administration would never enforce existing laws about predatory lending
practices or antitrust statutes or any of that, but there is always the chance
that the Democrats could get more votes than the Republicans could steal, and
this could cause consternation. You could end up with a crusading DA, something
investment bankers hate as much as members of the mafia do, and for pretty much
the same reasons.
If you have instruments and derivatives that aren’t regulated, then it doesn’t
much matter what you do, because it isn’t illegal. If things go to hell in a
hand basket, someone else is holding the bag and you have waltzed away with
millions of dollars you did nothing to earn.
That brings us to credit default swaps, or CDS. This has become a massively
popular way of covering risk, especially for investments on items based on
mortgages and bank loans in general.
Basically, a credit default swap means you are placing a bet on a third party
that pays off if they default. As an example, let’s say that I take out a CDS on
Osborne Computers. Osborne is a good solid outfit that is solvent and doesn’t
look like a risk to default. So the issuer is offering derivative notes on
Osborne at an annual premium of $10 for every $1,000 in coverage. I have $10K to
put in, so I buy one million dollars.
The following year, Osborne is doing even better, and I extend the coverage for
a year at the bargain price of $850. The issuer has recalculated Osborne’s
position, and estimates there is only a one in 150 chance Osborne will default.
He tosses in a house percentage, and comes up with a legit-looking number.
The following year, disaster strikes. Someone invents the color monitor, and
Osborne is out of business. They declare bankruptcy. I spend some time pondering
what I should spend my million on that I won for just $1,850, and go see the
guy.
Only he doesn’t have the money. He waves our contract in front of us, and right
there in tiny print it mentions that payment is contingent upon operating
assets, and he ain’t got none.
He wasn’t being irresponsible: he was holding a bunch of CDS of his own on
Osborne, but it turned out his guy couldn’t pay out, either. And his contract
had a similar escape clause.
All legal, because it’s unregulated. At least I didn’t add insult to injury and
actually own any Osborne stock.
Oh, didn’t I mention? You don’t need to own any interest in the company you are
buying CDSes as a hedge against. It’s a bit like buying life insurance on the
pedestrians out on the street, hoping that one of them will wander out in front
of a bus.
None of this benefits any of the companies involved. The issuers of CDS not only
are not required to have enough capital to cover reasonable payouts, the way
banks and insurance companies are, but they don’t have to tell the companies
what they are doing. The companies pay attention, of course, because the rates
on the premiums makes a statement about the financial health of the company; the
higher the premium rate, the more trouble the company is seen as being in.
Of course, you have people betting on what those rates will be in three months
or six months or a year. Lotta money switching hands even on that. All
unregulated, of course.
When Freddie Mac and Fannie Mae gave the Fed a massive scare by nearly
defaulting, word got out on just how much trading in these CDS derivatives there
is on the mortgage and loan industry.
It’s $64 trillion dollars. That’s “trillion” with a “T.” Sixty four million
million dollars. None of it is collateralized, none of it is marginalized. And,
even though the amount is five times the amount of the entire United States
Gross National Product, most of it doesn’t exist, other than in utterly
worthless promissary notes.
But the premiums on those notes amount to hundreds of billions of dollars, which
means some people have been getting immensely rich off of them. And they are
probably arranging it so if a complete crash of the mortgage industry does
occur, they can protect it against any type of legal judgement.
World wide it’s a vast bubble, estimated at nearly $700 trillion dollars, which
is more than ten times the entire planet’s GNPs.
When it goes, it means that not only will vast amounts of entirely imaginary
wealth vanish, but that huge amounts of real, honest-to-gosh money will vanish,
too.
Enough to make an economic recovery ten times more difficult.
Want to learn more? http://www.globalresearch.ca/index.php?context=va&aid=8634