Page 2 of 2 Next up - the credit default swap crisis
By F William Engdahl
technical definition of default - this requires proving which bond or loan
holders weren't paid - and the amount of payments due. Some fear that could in
turn freeze up the financial system.
Experts inside the CDS market now believe that the crisis will likely start
with hedge funds that will be unable to pay banks for contracts tied to at
least $150 billion in defaults. Banks will try to pre-empt this default
disaster by demanding hedge funds put up more collateral for potential losses.
That will not work as many of the funds won't have the cash to meet the banks'
demands for more collateral.
Sellers of protection aren't required by law to set aside reserves in
the CDS market. While banks ask protection sellers to put up some money when
making the trade, there are no industry standards. It would be the equivalent
of a licensed insurance company selling insurance protection against hurricane
damage with no reserves against potential claims.
Basle BIS worried
The Basle Bank for International Settlements, the supervisory organization of
the world's major central banks, is alarmed at the dangers. The Joint Forum of
the Basel Committee on Banking Supervision, an international group of banking,
insurance and securities regulators, wrote in April that the trillions of
dollars in swaps traded by hedge funds pose a threat to financial markets
around the world.
"It is difficult to develop a clear picture of which institutions are the
ultimate holders of some of the credit risk transferred," the report said. "It
can be difficult even to quantify the amount of risk that has been
transferred."
Counterparty risk can become complicated in a hurry. In a typical CDS deal, a
hedge fund will sell protection to a bank, which will then resell the same
protection to another bank, and such dealing will continue, sometimes in a
circle. That has created a huge concentration of risk. As one leading
derivatives trader expressed the process:
The risk keeps spinning
around and around in this daisy chain like a vortex. There are only six to 10
dealers who sit in the middle of all this. I don't think the regulators have
the information that they need to work that out.
Traders, and
even the banks that serve as dealers, don't always know exactly what is covered
by a credit-default-swap contract. There are numerous types of CDSs, some far
more complex than others. More than half of all CDSs cover indexes of companies
and debt securities, such as asset-backed securities, the Basel committee says.
The rest include coverage of a single company's debt or collateralized debt
obligations.
Banks usually send hedge funds, insurance companies and other institutional
investors e-mails throughout the day with bid and offer prices, as there is no
regulated exchange to price the market or to insure against loss. To find the
price of a swap on Ford Motor Co debt, for example, even sophisticated
investors might have to search through all of their daily e-mails.
Banks want secrecy
Banks have a vested interest in keeping the swaps market opaque, because as
dealers, the banks have a high volume of transactions, giving them an edge over
other buyers and sellers. Since customers don't necessarily know where the
market is, you can charge them much wider profit margins.
Banks try to balance the protection they've sold with credit-default swaps they
purchase from others, either on the same companies or indexes. They can also
create synthetic CDOs, which are packages of credit-default swaps the banks
sell to investors to get themselves protection.
The idea for the banks is to make a profit on each trade and avoid taking on
the swap's risk. As one CDO dealer puts it, "Dealers are just like bookies.
Bookies don't want to bet on games. Bookies just want to balance their books.
That's why they're called bookies."
Now as the economy contracts and bankruptcies spread across the United States
and beyond, there's a high probability that many who bought swap protection
will wind up in court trying to get their payouts. If things are collapsing
left and right, people will use any trick they can.
Last year, the Chicago Mercantile Exchange set up a federally regulated,
exchange-based market to trade CDSs. So far, it hasn't worked. It's been
boycotted by banks, which prefer to continue their trading privately.
F William Engdahl is the author of A Century of War:
Anglo-American Oil Politics and the New World Order, Pluto Press Ltd. Further
articles can be found at his website, www.engdahl.oilgeopolitics.net.
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