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Generational Dynamics Web Log for 4-Jun-2008
A clearer explanation of credit default swaps.

Web Log - June, 2008

A clearer explanation of credit default swaps.

How credit default swaps (CDSs) present a systemic risk to the global financial system is explained in a recent article by economics journalist Martin Hutchinson, writing for The Bear's Lair.

You should read the entire article, but I'll just comment on a couple of things about it.

"Under a CDS, one bank promises to pay another bank money if a particular debt obligation of a third party borrower defaults. The precise definition of “default”, the mechanism for calculating the amount of money payable and the extent to which the deal relates to general debts of the third party or to one particular obligation all vary between CDS, as do the maturity and amount. There is thus no easy mechanism whereby a liquid securities market could be created in CDS, since the differing terms of each transaction tend to make them un-substitutable."

The point is that each CDS is a unique contract between two people (two banks). Since these contracts aren't standardized, it's impossible to be sure that any two of them have the same value. Thus, they're not like stock shares in a corporate, where each share is equal in value to any other. Therefore, it's difficult or impossible to determine the values of an CDSs in an institution's portfolio.

(For those interested in the math behind the creation of CDOs from CDSs, see "A primer on financial engineering and structured finance." For a discussion of credit default swap (CDS) counterparty risk, see "Brilliant Nobel Prize winners in Economics blame credit bubble on 'the news.'")

"[In] a severe credit crisis, the potential losses on credit derivatives may indeed approach ... 10% of $62.3 trillion or $6.23 trillion, several times the capital base of the entire US banking system, more than the current total of Federal government debt outstanding and about 40% of a year’s US Gross Domestic Product. That would make a credit derivatives crash far larger in monetary terms and somewhat larger in terms of the economy than the Japanese banking problems of the 1990s, which caused 13 years of recession in that country."

This is the crucial point. There are $62.3 trillion of these CDSs out there. A 10% failure would not be surprising in case of a severe credit crisis, and it would have catastrophic effects.

The most amusing paragraph is this one:

"It is clear what has led to the tottering and bloated nature of the credit derivatives market: the perverse incentives of Wall Street. Senior traders are rewarded with “drop dead money” – amounts that enable them to leave the business at any time, financially secure for life, with only the distant threat of long-term imprisonment to deter them. Since the financial services industry also works excessive hours, allowing little time for reflection and intellectual stimulation, a high proportion of its inmates become possessed with a monomaniacal urge to accumulate the cherished “drop dead money.”

This is the contradiction. If senior traders faced even the "distant threat of long-term imprisonment," then what they did is already illegal, and it doesn't make any difference whether new laws and regulations are implemented.

It never dawns on anyone to ask why so many people -- in every organization, at every level -- committed some kind of fraud for their own personal gain, or at least condoned such fraud. People in my parents' generation would not have done this.

The housing bubble was caused by massive fraud throughout the entire financial and real estate industries, from top to bottom, whether it was homeowners lying on their applications, construction firms colluding with appraisers and brokers to get kickbacks by over-valuing homes, lenders who resold mortgages without checking any of the claims, lenders who adopted predatory lending practices, granting loans to people with no hope of making payments, investment banks that securitized loans based on the assumption that real estate prices would rise forever, ratings firms and monoline insurers that took fat fees to lie about these potentially worthless securities.

The only possible explanation for such ubiquitous debauchery is generational. There's no other way that it could have reached every corner of every financial and real estate organization except in the contemptuous attitudes of nihilistic Generation-Xers, perpetrating fraud right under the noses of their stupid Boomer bosses, who condone the crimes because they also gain. This lethal combination of Gen-X nihilism, combined with Boomer stupidity is what got us where we are.

Here's an investigative story from the The Milwaukee Journal Sentinel, a case study in "liar loan" fraud in which one person after another commits fraud:

"As housing prices were rising year after year, lenders across the country had eased underwriting standards. As a result, many homebuyers were able to secure high-interest loans without disclosing such basic information as their employment, income or assets. The real estate boom stalled, and many subprime borrowers found themselves unable to refinance or sell their homes.

In Medellin's case, the deal wouldn't have been possible without the motley collection of individuals and firms eager to get a piece of the 8.75% loan and the fees that went with it."

The article goes into a great deal of detail, but the bottom line is this: There isn't a single person in the story who had any moral or ethical standards. It was one crook after another.

I've gotten several e-mail messages in the last couple of weeks asking me why I sometimes sound so "angry." I was asked, "Why are you so angry today?"

Anyway, the reason I was "so angry" that day is because I'm angry every day. The stench of corruption and fraud is overwhelming, and the coming disaster will be the worst in history. After writing this web site for six years, I don't know how I could be anything BUT angry.

What I've discovered in the last couple of years has shocked me beyond belief. The depth of financial debauchery is staggering. If someone had told me even 2-3 years ago what I would find, I wouldn't have believed it possible. I can hardly believe it's possible now, but there's no doubt about it.

In Hannah Arendt's study of the Nazi Germany in the book, The Origins of Totalitarianism (p. 335), she describes the enormous level of corruption at the time, and how it was reflected in Bertolt Brecht's play, The Three-Penny Opera [Dreigroschenoper], which presented gangsters as respectable businessmen and respectable businessmen as gangsters. The theme song for the play was "Erst kommt das Fressen, dann kommt die Moral," best translated as "First comes gluttony, then comes morality."

Today, financial institutions are openly avoiding providing realistic market values for their CDO and CDS assets, and they're continuing to defraud investors and the public. All we can do is hope that the "distant threat of long-term imprisonment" turns into an immediate threat, since we're in the same place today as Germany was in the 1930s: there's no difference between respectable businessmen and gangsters. (4-Jun-2008) Permanent Link
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Generational Dynamics Web Log for 4-Jun-2008 A clearer explanation of credit default swaps.

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Generational Dynamics Web Log for 4-Jun-2008
A clearer explanation of credit default swaps.