Why We’re Not Out Of The Financial Woods Yet

Contrary to quite a few popular opinions you may be hearing these days, the root cause of our finanical meltdown is not the decrease in value of home across the country. Instead, it’s the failed monetary policy of central banks around the world over the last 20-30 years, specifically our own Federal Reserve. In fact, the housing market collapse isn’t even the worst symptom of this failed policy. From the beginning, the derivative market has had the greatest responsibility in perpetuating the meltdown. And the sad news is, it’s probably not over yet.

You’ve probably heard about such investment vehicles as Collateralized Debt Obligations and Credit Default Swaps a lot lately if you read anything about the financial problems. The latter are what may still contribute to a failure in the financial markets as the exposure to bad debt there is still largely unknown.

Let’s talk a little about CDS first. At their most basic, a CDS is a way for an investor to hedge risk for an investment he owns. For example, let’s say I buy a bond from company XYZ. However, I would like to make sure that my bond doesn’t become worthless should company XYZ default or go bankrupt. So I can buy a CDS from a bank, we’ll call them bank ABC. A CDS has two parties, a buyer of protection and the seller of protection. Here, I’m the buyer and ABC is the seller. Without going into the math, let’s just say I buy a CDS from bank ABC by agreeing to pay them quarterly payments throughout the life of the bond in exchange for protection (or insurance if you want to think about it that way) in case Company XYZ defaults. If they do, bank ABC agrees to settle with me by paying me a lump sum which can vary depending on the settlement method.

Once this CDS is set up, three things can happen.

  • Company XYZ doesn’t default, I make all my payments to Bank ABC while collecting on the interest from the bond as well as the principal at the end of the term and everyone goes home happy.
  • Company XYZ does default, I stop making quarterly payments to Bank ABC and they pay me a cash settlement which is somewhere between the par value (face value) on the bond and the market price of the bond (even when a company defaults, there is money left around typically so the bond is worth something).
  • Company XYZ does default, I stop making quarterly payments and Bank ABC pays me the par value of the bond in exchange for the physical bond.

One important thing to understand is that by entering into a credit default swap, I have taken on counterparty risk, i.e. if both Company XYZ defaults and Bank ABC defaults, I’m up shit creek with much toilet paper. This is important when we talk about big sellers of protection that have been in the news lately, say like Lehman Brothers or AIG.

None of this is very problematic in the scenario above. Where things get real sticky is when investors use CDS to speculate on companies without owning the underlying asset class or bond. For example, during the last few years, it was completely commonplace for investors (and by investor, I’m not talking about you and me, I’m talking about pension funds, large banks and hedge funds) to buy CDS without owning the bond. Looking at my example above, let’s say I don’t own Company XYZ’s bond but I think there’s a good chance they are going to default. I could still buy protection from Bank ABC as a speculative gamble and then if XYZ does default, Bank ABC has to pay me.

What does all this have to do with our financial markets? The problem lies in the fact that this market is not exactly transparent and no one really knows the levels of CDS out there. The Depository Trust and Clearing Corp (DTCC) runs a warehouse for CDS trade confirmations that supposedly accounts for 90% of the total market. However, this is misleading because the DTCC only tracks transactions for which there was a cash settlement and not any physical settlments. They also do not track settlements for CDS written on CDO which is both a major market in and of itself as well as a major source of failures over the past months. Let’s look at Lehman Brothers as an example.

When Lehman Brothers went belly up this year, one of the great unknowns was how exposed to the CDS market they were. An auction of Lehman’s bonds on October 10th set the market value at 8.625 cents on the dollar. Sellers could now settle in cash with the buyers at a price somewhere between 8.625 cents and 1 dollar for every dollar in bonds or they could pay face value for bonds in exchange for the physical Lehman Brothers bond. Now, intuitively, you’d think that they would never want to pay face value for a defaulted bond and thus, would cash settle with all the CDS buyers. This intuitive notion is why lots of people wrote about the Lehman Brothers credit event being a non-event, i.e. the published value of this settlement was pretty low and there didn’t seem to be a lot of exposure to the Lehman Brothers default. The problem with this is that it’s quite possible that lots of sellers of CDS decided to take physical settlement. Why in the hell would they do this? As in most things financial these days, they’d do it to cover their own asses.

You see, when you take cash settlement, that event immediately goes on your financial books as a big time loss. But as I understand the accounting rules, if you take physical settlement, you don’t have to put that on the books because by accounting terms, you’ve just paid out money in exchange for an asset of the same value, even though the asset is defaulted. So if you’re a CEO of a big company and you are heavily exposed to a CDS like this, you might want to demand physical settlment so that your books don’t take a monster hit and because at this point, the debt is worth almost nothing so you risk little in taking the debt on the off chance that eventually it’s worth more than the cash settlement. You can see that there might be a big market in physical settlements as companies choose to hide losses. Since these aren’t tracked by the DTCC, we can’t know how big these failures are.

So in reality, we have very little idea concerning our remaining exposure to the CDS market. This is completely ignoring the fact that lots of sellers of protection, including Lehman, went or are going under which is a catastrophe for anyone who tried to hedge risky market moves with CDS only to find out that the seller of their protection was just as risky.

As you can see, we’re probably going to have to chop down a lot more trees to get out of the woods on this deal. Bloomberg had a great article yesterday on this same topic. Our financial house is still a mess and that doesn’t even begin to consider the recession we’re currently entering which promises to be one of the worst we’ve seen in decades. This will be no 2 quarter recession followed by rapid gains. We’re looking at a long-term, probably 8-10 quarters minimum if I’m guessing right. Job losses are already mounting and will only continue to get worse. We’ve (and by we, I mean the idiots we have running the Federal Reserve and Treasury departments) been putting this off for a long time and anytime you put off a disaster, it typically becomes a catastrophe. Until we can figure out the true risk involved in the exotic derivatives market, we’re going to be struggling for a long time.

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