Credit Default Swaps: How Fleas Kill A Dog

February 26, 2009

I've been on the lookout for an article with a concise description of the ongoing saga of the Credit Default Swaps (CDS) markets to pass along to readers and I have found a nice, simple one on the Guardian UK website. This article is written at a level any newbie can understand yet provides current news any veteran would appreciate. As a bonus, it conveys, once again, the scale of the debt bubble the world economy is trying to swallow which is now widely recognized as massive.

What's particularly interesting to me about this short article is that it highlights a problem I liken to "fleas killing a dog". Once a pregnant flea moves in and begins to reproduce, her offspring will, in time, overpower the immune system of the dog and will eventually kill him. The analogy couldn't be closer to what's being done now to the world financial system (the infested dog) by the opportunistic hedge funds (prolific and potentially lethal blood-sucking parasites).

One major flaw in my analogy a bright analyst might immediately recognize is that, IN THIS STRANGE CASE, EACH FLEA STARTS OUT EXACTLY THE SAME SIZE AS THE DOG! AND, EACH DOG HAS POTENTIALLY HUNDREDS OR EVEN THOUSANDS OF FLEAS! Obviously, the poor thing doesn't stand a chance.

Here's an important excerpt from the original Guardian article:

"Banks in Europe and the US face a new wave of losses linked to contracts issued to insure against companies going bust and defaulting on their loans, City analysts have warned.

After the billions lost over the US sub-prime market and leveraged loans, investment banks such as Morgan Stanley, Deutsche Bank, Barclays, UBS and RBS face losses on credit default swaps (CDS) - contracts that allow an investor to be repaid if a company loan or a bond defaults.

CDS contracts became a favourite tool of speculators, mostly hedge funds, which bought the contracts without having any link to the original lending. They bought the contract to trade or in the expectation the company would in fact default, meaning they could claim back the full value of a loan they never made.

The CDS market exploded to be worth as much as $50tn, many times the size of the underlying assets. Each loan could have thousands of protection contracts, even if there were only a few lenders. Hedge funds accounted for about 60% of CDS trading, according to ratings agency Fitch."

The entire article can be found here:

Banks Face New Wave of Losses on CDS Contracts, Analysts Warn

Notice the interesting problem we're facing due to CDS's. Hedge funds (rich "accredited" investors), as primary purchasers of CDS's, have been able to convince the institutions - major commercial and investment banks - who should be the stewards, protectors, and guardians of the world's capital that's entrusted to them to "insure" the hedge funds against defaults on third-party debts that are not even owed to them with money these banks never even had.

The scale of this potential $50 trillion problem? Well, let's put it in these terms. I recently heard that the total capital base of all the major U.S. banks had been in the range of $1.4 to $1.6 trillion, at least until the recent debacle struck.

Put another way, the OPEC nations brought in total net oil revenues of $671 billion in 2007. In 2008, they brought in closer to $1 trillion due to record-breaking oil prices during the first half of the year. This is big money but it looks embarrassingly puny when laid toe-to-toe with the $50 trillion of "insurance" that's been sold on debts "covered" by CDS's. And, bear in mind, CDS's are just one aspect of the overall derivatives problem.

A December 2008 "Flow of Funds Report" from the Federal Reserve Board showed the total value of all owner-occupied U.S. residential real estate (including homes, non-rented 2nd homes, trailers, and vacant land) at $19.1 trillion. That same report showed total financial wealth in the U.S. at $45.3 trillion and total wealth at $71.1 trillion. A $50 trillion problem is a world-class problem.

By any measure, you can see that the $50 trillion "ransom" that can potentially be demanded by the hedge funds as a claim against a rotten wager agreed to by the leverage-crazed bankers - with money we entrusted to them - will cost "the system" dearly and, of course, the system is US. These claims should all be immediately nullified by world courts to relieve if not save the system. But this isn't being done!

Now, in case you've forgotten, let me remind you what a CDS is really like through a little story. Imagine that you own a home with a $200K mortgage on it that's owed to Main Street Bank in your town. Now imagine that your neighbor down the street whom you've never met approaches a different bank - 1st CDS Bank - and tells them that he wishes to buy "insurance" against a possible default on your mortgage (insuring the whole amount you owe, though not a penny is owed to him) and, as consideration for this contract of pure speculation, he agrees to pay the 1st CDS Bank an annual "fee" or premium for this service. The banker at 1st CDS Bank looks around him, notices no one's looking - and is confident he could "hide" the deal even if someone were looking - and says "Sure, why not? We've got a deal!" They shake hands and draw up the paperwork.

While times are good, your credit appears sound, and your payment history is respectable, 1st CDS Bank sees little risk, loves the agreement and rapidly expands their new-found "profit-center" operation, generously offering similar CDS contracts to several dozen of your sport-loving neighbors - who all eagerly jump on board.

Naturally, word quickly spreads about this spirited new source of instant bank-profits and soon other banks are joining in on the boisterous action, too. Before long hundreds, then thousands of people around your town, your state, and even across the nation OWN CONTRACTS ON THE POSSIBLE DEFAULT OF YOUR MORTGAGE - JUST ONE SINGLE MORTGAGE. Agreements totaling millions upon millions of real dollars must be paid out to the gamblers by the banks immediately upon the simple default of your lonely little $200k mortgage.

Sound impossible? Welcome to the world of the credit default swap.

Now, with all these people standing to gain from your incapacity or bankruptcy, I'd hate to even imagine the shady if not downright dirty and dangerous dealings it could spawn. You'd be living as a marked man with thousands of "contract holders" hoping you'd lose your job, become disabled, or worse. You'd have few friends but a lot of nosy "observers" and strange dark cars parking near your house day and night. Surely, they couldn't all be well-intentioned and watching out for your best interests!

Now imagine your mortgage in the story above is actually the debt of a major corporation and your home is the corporation, like say, General Motors or Chrysler or maybe even a huge insurance company like AIG.

In the corporate world where trillions of dollars are at stake, my imagination literally springs to life with all the kinds of things that could be conjured up to opaquely engineer a massive corporate default, as I'm sure yours does, too. Just the thought is chilling. Such a financial demolition plan could begin with the careful over-leveraging of the company's balance sheet and a market-popping buy-back of too much stock at too high a price, a few poor-performing product lines, a costly yet ineffective marketing campaign, a few well-placed rumors of internal weakness, all topped off with steadily increasing naked short-selling by "a few hedge fund buddies" - and the whole thing could snowball from there. Heck, some of the executives inside the company might even help out if they're paid enough!

Think about it, what's to stop or even detect this kind of vicious and insidious activity? Who's to say it wasn't done or isn't being done in some of these companies? Surely, fiduciary duty doesn't count for anything these days as we can plainly see.

That the courts would allow these simple paper contracts to exist solely to benefit gamblers let alone jeopardize much of the socioeconomic progress of the last 50+ years is beyond me. Where is the logic? Where is the reason? Where is the sanity? Historically dangerous contracts be damned! Why isn't this proposal or some version of it front and center on the desk of every government official in the world?

Perhaps it's time it got there. Perhaps it's time we rid our beloved old dog of the fleas that are killing him. These fleas are a lethally large and thirsty new variety and we can clearly see that they won't stop at dogs - or third world economies. Their sights are set on you and me. And they're beginning to feed.

For more interesting and insightful articles please visit our website at: www.haasfinancial.com

The California Gold Rush began on January 24, 1848 when gold was found by James W. Marshall at Sutter's Mill in Coloma.