Thursday, November 27, 2008

Credit Default Swaps. Too Big To Fail. Too Big To Bail Out.



The Credit Default Swap Market is estimated at $60 Trillion Dollars to $75 Trillion Dollars. The Current US Stock Market Capitalization is between $7 and $10 Trillion Dollars now. The Credit Default Swap Market is enormous and posses many unknown risks to the global financial system.

60 Minutes did a great piece about how this market compared with the old "Bucket Shops" that allowed customers to place large leveraged bets on stocks without much capital. Many people think this is the reason for the stock market crash of 1929. The States drafted legislation to prohibit these Bucket Shops. Then came of Commodity Futures and Modernization act of 2000.

This eliminated the old bucket shop laws and allowed the Credit Default Swap Market to flourish. The New Act Eliminated the enforcement of these "Bucket Shop" Laws. The Regulators created these laws after the 1929 financial crisis to prevent another crisis. The Regulators of our time undid these regulations to allow the markets to be free. They reasoned in our modern advanced financial society, large institutions had the intelligence and economic incentive to effectively manage risk, and they did not need outdated, burdensome government regulations to inhibit the flow of capital and compromise the sanctity and prosperity of the free markets.

A Credit Default Swap is an insurance policy to speculate on the default of a company. Since these are legally classified as "swap" contracts, and not actual "insurance" contracts, none of the collateral and minimum capital reserve rules of the insurance industry apply. This was intentional on the part of those who lobbied for this legislation. No one in a swap transaction is required to post much of any collateral to cover the risk of a credit event actually happening.

We know now that many of the people who wrote these contracts do not have the ability to actually pay on these claims. These Contracts were all sold by the Largest Financial Institutions, they were the cause of death for Bear Sterns, Lehman Brothers, and the cost of Billions of Dollars in write downs for too many companies to name.

Because of tricky accounting laws these swaps were written using special investment vehicles and other "off balance sheet" type of stuff. The words Off Balance Sheet even to the layest of lay people sound dubiously suspicious. It is so obvious this tactic was mean to deceive and cloud what should be clear black and white accounting rules, standards, and practices it is blatantly insulting.

The Markets are adjusting constantly with each new piece of data and information to reprice the risks and effect of these mysterious credit default swaps, special investment vehicles, mortgage backed securities, and other opaque, illiquid, hard to value, and even harder to sell securities.

It is going to be necessary for a central clearing house to stand behind the credit default swap market. The Chicago Mercantile Exchange (CME) and The Intercontinental Futures Exchange (ICE) are both licking their chops in anticipation of a new government regulated market for the swaps, and have both made proposals. Increased transparency and accountability in this market is essential for the survival and evolution of capitalism. The Obama Economic Team is going to have to handle this sticky task when they take office this January.

The Credit Default Swap Market is both Too Big To Fail and Too Big To Bail out.

Yes you read that last sentence properly. There is not enough money available for any government anywhere on earth to "inject capital", "provide liquidity" or really help ease these markets. Adding more money is not an option. These markets need to work themselves out on their own, for better or for worse. No one really knows for sure how everything is going to play out.

In 5 years from now you could be buying your girlfriend the newest designer purse as a surprise luxury treat, or stealing an old ladies purse to quiet your stomach rumblings to eat. Only time will tell.

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