STATICRHETORIC

by C.S. Jefferson

THE 60 TRILLION DOLLAR NIGHTMARE OF CREDIT DEFAULT SWAPS

The 60 plus trillion dollar nightmare of the CDS (Credit Default Swaps) market is a dangerous anomaly of the tail wagging the dog, pushing risk premium higher against a downward spiral of collapsing market capitalization and lowered credit ratings for corporate debt.

Imagine, 60 plus trillion dollars in total existing liabilities in the unregulated OTC (Over-The-Counter) market of Credit Default Swaps means that our government, in fact, all governments interconnected in the global economy could not possibly “bail out” that entire amount if ever forced to claim. That’s more than the entire world’s GDP combined!

I am very pleased to hear that the Federal Reserve is taking measures to act as a potential counter-party to the commercial paper market that has remained frozen, as institutions are unwilling to lend short-term debt without a reliable bond insurance guarantee in swaps through the OTC market.

The Chicago Mercantile Exchange (CME) is the first major exchange taking initiatives to create a dynamic and transparent market for Credit Default Swaps and, most importantly, a clearing function that adds liquidity and accountability in a regulated forum. But we are up against the clock and in order to truly facilitate liquidity in the tight credit markets, there must be a viable alternative to achieve price discovery in guaranteed bond and debt insurance.

However, since these are unusual times when conventional rules don’t apply, I would like to see the Federal Reserve in combination with the proper regulatory body step in and disqualify all existing Credit Default Swaps in the OTC market. The OTC market is a rabid beast out of control that needs to be put down before the contagion spreads irreversibly.

For those that don’t know, Credit Default Swaps are essentially an insurance contract that company A would use to hedge against loaning money to company B in case the borrower, or Company B, were in default and unable to repay the existing loan.

The intention was good but we all know where that road leads…

The problem was that like any bubble reaching its elliptical peak, the CDS market became absolutely inundated with speculators that were flipping these insurance contracts in a very opaque, highly illiquid and non-transparent unregulated market.

When the economy was thriving, the risk of default was very low against corporate debt and it was an easy and understandably, lucrative business to “sell insurance premium” without undue caution or concern of paying out on the claim. This is the reason that A.I.G. was bailed out by the Treasury with an $80 plus billion dollar bridge loan. The risk of default was systemic and A.I.G. was sitting at the heart of this market as the premiere counter-party that sold insurance.

But, the problems were worse as hotshot speculators also jumped in selling these insurance contracts without any accountable requirement to maintain margins or the potential ability to pay these claims. This may be the worst example of free markets gone wild, when the money was free and no one was there to play babysitter and govern unquantifiable liability.

Since the CDS market remains an unregulated OTC market, in my opinion, there should be no reason that it can’t be shut down completely. Just disband the entire racket and have the dirty, smoke filled gambling den closed for business permanently.

This is the opportune moment to commit such drastic action and invalidate a monster liability on the entire global financial system that is dragging the markets down the drain. You could do this by, simultaneously, providing a regulated, transparent Credit Default Swap market on major exchanges like the CME and allow the transition to be as seamless as possible without incurring overwhelming risk to lenders by unhedged loans.

Perhaps, as part of the transition to a regulated swap market on an open exchange, you could stipulate and insist that all open or existing contracts are null and void, that counter-parties remain obligated to redeem the “insurance premium” paid and received only. By mandating some type of enforcement to this unregulated market, you could remove the potential liability from unrecoverable claims that hang like a noose around the neck of the entire economy.

Firms that sold premium or Credit Default Swaps were not even required to put up a substantial margin, less than pennies on the dollar, which means that any firm that bought bond insurance against potential default risk of debtors were basically uninsured if they ever had to make a claim. The entire market was so undercapitalized that it is nothing short of criminal neglect to have allowed this avalanche of default liability to escalate to levels that were reached. This was a scam no different than unscrupulous fly-by-night life insurance companies that sell innocent people a promise without the intention of ever paying a claim.

It’s speculative risk so out of control that it makes a crack addict with a stimulus check look like a savvy investor. This should never have been allowed to get where it has, completely over leveraged and threatening to bring down this house of cards. The spreads are so insane in risk premium that they are pricing solvent corporations to the point of bankruptcy or, even worse, the entire global economy heading into an unrecoverable and sustained depression. The unregulated OTC market of swaps is the smoking gun holding the entire economy hostage to unregulated credit risk exposure.

This entry was posted on Tuesday, October 7th, 2008 at 7:05 pm and is filed under POLITICS, DIATRIBES AND EDIBLE RANTS, TRADING AND INVESTMENT STRATEGIES, U.S. MARKETS AND THE GLOBAL ECONOMY. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.