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CDS Failure Continues to Drive Housing Problems Blow by Blow

February 14, 2011


The key finding [in the FCIC report] is that chief executives were “30 times more likely to be involved in a sell trade compared with an open-market buy trade” of their own bank’s stock and “the dollar value of sales of stock by bank C.E.O.’s of their own bank’s stock is about 100 times the dollar value of open market buys.” (See page 4 of the report.)

– Simon Johnson, Ship of Knaves

I think what many people failed to understand when the credit collapse occurred in October 2008, is the housing downturn was directly linked to the credit default swap market which took a nose dive to the tune tens of trillions of dollars. It was not a failure in stocks – it was a failure in the credit markets taking a broadside by the crashing CDS market. Only a few news sources were tracking the developing situation in 2007 and 2008: Gretchen Morgenson of the NY Times in her columns and on NPR Fresh Air, Bloomberg Financial, and Money Morning. The mainstream media by and large completely shied away from the dangerous trend shunning their duty as watchdogs AND has done the same since the collapse in underreporting the causes.

With the documentary, Inside Job, and NPRs Frontline, and now the recent FCIC report, the general public can avail themselves of what really happened. But it seems as though people are just not interested in knowing. They want to continue to think of this as a stock market fluke, or strictly a political problem. Or, they are thinking it was bad practices at Fannie Mae and Freddie Mac, or a few bad banks. In fact, it was a confluence of specific events and specific participants. Poor business practices were at the heart of the whole thing. Widespread unethical dealings at all the major Wall Street banks, lack of government oversight of MBS’s and CDOs, casino style trading of unregulated swaps, and widescale sub-prime lending to unqualified borrowers, ALL contributed to the collapse. The problems were far from any normal stock market correction.

NY Times reports today:
“When I go out and talk to people around town, they say, ‘Wow, I thought we were going to have a 12 percent correction and call it a day,’ ” said Stan Humphries, chief economist for the housing site Zillow, which is based in Seattle. “But this thing just keeps on going.”

Seattle is down about 31 percent from its mid-2007 peak and, according to Zillow’s calculations, still has as much as 10 percent to fall. Mr. Humphries estimates the rest of the country will drop a further 5 and 7 percent as last year’s tax credits for home buyers continue to wear off.

You cannot lose $24 trillion and think of that as a normal correction. This was a severe collapse of financial markets worldwide. Back in April 2008, MoneyMorning reported the credit default swap market at around $50 billion:

Of all the really bad ideas that have infested the finance business in the last 30 years, the most dangerous is probably the credit default swap (CDS).

CDS is almost a brand new investment vehicle, but the market is already 20 times its size in 2000. The principal amount of CDS outstanding equals $50 trillion, or more than three times the U.S. Gross Domestic Product and bigger than all the U.S. credit markets put together. And the CDS has been a huge source of “financial engineering” profits, both for Wall Street and the hedge fund community over the last few years.

The article goes on to explain the risk and underlying problems with credit default swaps:

Under a CDS, a bank originates a loan to a company. A second bank (or other financial institution) can agree to cover the credit risk for the loan, by agreeing to make payment to originating bank if the company defaults on the original loan. The originating bank pays a small insurance premium to the second bank for assuming the risk of the loan. [That’s the swap]

Typically, payments under a CDS would only be triggered by the company’s failure to pay interest or principal on its debts [home loans] due to bankruptcy or some other severe liquidity issue [borrower defaults]. But there are a host of intermediate or special cases that will doubtless provoke lawsuits when something goes wrong (CDS being a new market, it is by no means “recession-proof”).

Here’s the ruse:

Credit default swaps were sold to the world as hedging transactions. Investors were told that they were simply transfers of risk, so that banks that made [home] loans could transfer credit risks to [private] insurance companies, which did not make loans directly, or to foreign banks that could not easily make loans in the U.S. market.

BUT, CDS are unregulated and thus the private insurance companies were not required to keep a certain amount of capital reserves on hand to cover the risk – meaning, there was not enough money to cover defaulting home loans when the collapse occurred in fall of 2008. The cascade of events put into motion the entire collapse of this house of cards. The swaps were grossly inadequate to cover the losses AND thus, American taxpayers were on the hook for trillions of dollars of losses.

the article continues…..

And if an originating bank sells its loan exposure only once, and sells it to a financial firm of undoubtedly solid credit, the CDS does indeed act as a hedge for the originating bank; it transfers the company’s credit risk from the bank to the financial firm that bought its CDS. But the product did not work as advertised.

Here comes the reality check — remember, this was reported in April 2008 just as Bear Stearns was experiencing problems which was the first firm to go down.

Suddenly home mortgages along with corporate credit and other types of consumer credit are in question and loss rates, which were very low in 2005-06, are soaring. That spells big trouble for credit default swaps.

If just 10% of CDS underlying risks go bust, somewhere in the financial system there will be $5 trillion in losses.

Yes, there could well be $5 trillion of profits elsewhere in the system, because derivative transactions theoretically balance out. BUT once defaults start piling up, it’s possible that many of those losses will become real, while the profits simply won’t.

And “theoretically”, they did not balance out. The losses starting piling up and up into the trillions of dollars and within months there was not enough capital reserves to cover them. The cascade of events accelerated and froze the credit markets worldwide in fall of 2008. It was a Ponzi-scheme of overwhelming proportions.

By the end of 2007, the outstanding amount was actually $62.2 trillion, falling to $38.6 trillion by the end of 2008. I picked this up on Bloomberg Financial and also heard it on one of the Fresh Air show’s with Gretchen Morgenson in 2008. So, the math is easy. For the year, 2008: $24 trillion was lost. That does not count 2009 or 2010. The paltry $700 billion TARP that Treasury Secretary Paulson asked for in emergency funds was laughable. In fact, one wonders why that amount was even proposed what was it’s real purpose. On a good year, the United States GDP is around $13-15 trillion. The United States Treasury cannot cover a $24 trillion-plus loss. THIS, is why the economy is dragging as we are still not dealing with the deep losses. This is why programs are being cut and more pain will be felt. This is why we are seeing upheaval across the Middle East. The fallout has affected the whole world. And guess what? Credit Default Swaps are still unregulated. Speculators have moved into the commodities markets — food, fuel, oil and cotton — and driving those markets artificially higher so emerging markets are being strained as to affordability of food and fuel. This largely drove the Egyptian revolt.

So, no small wonder that Fed Chairman Bernanke stated last week to Congress that employment may not return to pre-2007 levels for 10 years. And housing is linked to people’s ability to afford one! So, housing will not recover perhaps for 10 years.

Bear Stearns
The collapse of the company was a prelude to the risk management meltdown of the Wall Street investment bank industry in September 2008, and the subsequent global financial crisis and recession. In January 2010, JPMorgan discontinued use of the Bear Stearns name.

JP Morgan Chase is one of the Big Four banks of the United States with Bank of America, Citigroup and Wells Fargo. On February 4, 2011, Global financial services firm JPMorgan Chase & Co was ”at the very centre” of and ”complicit” in the USD 50 billion Ponzi scheme masterminded by disgraced investment manager Bernard Madoff, a lawsuit filed in a US bankruptcy court has alleged. The USD 6.4 billion lawsuit filed by Irving Picard, a court-appointed trustee seeking to recover money for former Madoff clients, alleges that despite being aware of the fraud, the US bank continued to do business with the scamster in the hope of protecting the bank’s investments.

Credit Default Swap – Market Stats
Notional value of CDS Market in 2001: $630 billion
In 2008: Over $50 trillion
By end of 2009: $36 trillion

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