Credit Default Swaps and the Shock Doctrine

[lostnfound]

Another thread cracks open a nut that needs further discussion. It behooves us to learn something about Credit Default Swaps. They can be used as hedges (to hedge legitimate business risks) or they can simply be a means of speculation.

As speculation, they amount to unfunded gambling, betting on whether or not a set of loans will be paid. One entity -- a bank or insurance company and they don't even have to be a party to the loans -- can collect $100,000 a year from another entity -- it could be a loanholder who is worried that a $10 million loan is going to go into default, or it could be another third party speculator who isn't even party to the loans, or who happens to have inside information. The first entity is happy to collect the $100K which is pure profit as long as the loans don't go into default. But if the loan in fact does go into default, the first party must pay the second party $10 million. The payoff amount can be far higher than the amount of the loans in default.

Skinner, if I pay DU $100,000 a year, would DU agree to pay me $10 million if a certain freeper website defaults on its debts next year? Jackpot!

An unscrupulous entity might be glad to take $100K and run with it, planning to abscond and default if the obligation to pay $10 million ever actually occurs. In this case, major banks and insurance companies have taken such bets, and Paulsen is proposing that we taxpayers take the hit.

What's even worse, the entities to whom the $10 million is owed may not even have a business need for it. Or they may in turn have sold their rights to a fourth party or fifth party etc. But because the "Bankruptcy Abuse Prevention and Consumer Protection Act of 2005" gives special protection to credit default swap payoffs, the banks or insurance companies must pay off the $10 million as their top priority.

And regulation of Credit Default Swaps was stopped by the Commodity Futures Modernization Act which passed in 2000 -- sponsored by Rep. Thomas Ewing and cosponsered by Rep. Tom Bliley (R-VA) Rep. Larry Combest (R-TX) Rep. John LaFalce (D-NY) Rep. James Leach (R-IA); and by Sen. Richard Lugar (R-IN) and cosponsored by Sen. Peter Fitzgerald (R-IL) Sen. Phil Gramm (R-TX) Sen. Charles Hagel (R-NE) Sen. Thomas Harkin (D-IA) Sen. Tim Johnson (D-SD), but never debated in the Senate or House. It was stuffed into the big appropriations bill (by the Republican leadership of Congress I assume), and signed by Clinton on December 21, 2000.

Per Wikipedia

It is also possible to buy and sell credit default swaps that are outstanding. Like the bonds themselves, the cost to purchase the swap from another party may fluctuate as the perceived credit quality of the underlying company changes. Swap prices typically decline when creditworthiness improves, and rise when it worsens. But these pricing differences are amplified compared to bonds. Therefore someone who believes that a company's credit quality would change could potentially profit much more from investing in swaps than in the underlying bonds, although encountering a greater loss potential.

So the secret parties to this gambling easily could have been playing all sides of the game -- making profits for their friends at the banks like Goldman Sachs in the early year since 2000 (collecting the premiums), and profits for their other friends who bought credit default swaps in the later years to collect on the payoffs. Now they intend to leave taxpayers holding the bag -- which is giving us a big shock. How else could you give a devastating blow to a giant, fairly strong economy like the United States in 2000? It feels as if we've been given a 1-2-3 punch: first was 9-11, second has been the trillion dollar wars, and now this.

Enough to knock a giant over. When other countries got knocked down via massive debt, they were put in chains by those who came after: the old administrations on their way out; the World Bank or IMF; the debtholders. The chains took away their sovereignty and precluded populist movements from softening the blow for the ordinary citizens. This giant will have a long road to recovery. Can Congress find a way to redirect the third punch?

[pnwmom]

1. And the scariest thing of all:

we have an estimated 62 TRILLION dollars worth of this unregulated debt attached to our economy.

Unimaginable.

[dkf]

2. Looks like NYs Patterson is stepping into regulation of CDS.

http://www.democraticunderground.com/discuss/duboard.php?az=view_all&address=114x43968

Interesting...

[pnwmom]

3. It is interesting but also unclear.

If speculative credit swaps won't be counted under "the plan", then what happens to them?

[PA Democrat]

4. Warren Buffet back in 2002 described CDSs & other forms of derivatives as "weapons of mass

destruction. Interesting article on derivatives from March of this year:

http://www.marketwatch.com/news/story/derivatives-new-ticking-time-bomb/story.aspx?guid=%7BB9E54A5D-4796-4D0D-AC9E-D9124B59D436%7D

<snip>

The fact is, derivatives have become the world's biggest "black market," exceeding the illicit traffic in stuff like arms, drugs, alcohol, gambling, cigarettes, stolen art and pirated movies. Why? Because like all black markets, derivatives are a perfect way of getting rich while avoiding taxes and government regulations. And in today's slowdown, plus a volatile global market, Wall Street knows derivatives remain a lucrative business.

Recently Pimco's bond fund king Bill Gross said "What we are witnessing is essentially the breakdown of our modern-day banking system, a complex of leveraged lending so hard to understand that Federal Reserve Chairman Ben Bernanke required a face-to-face refresher course from hedge fund managers in mid-August." In short, not only Warren Buffett, but Bond King Bill Gross, our Fed Chairman Ben Bernanke, the Treasury Secretary Henry Paulson and the rest of America's leaders can't "figure out" the world's $516 trillion derivatives.

Why? Gross says we are creating a new "shadow banking system." Derivatives are now not just risk management tools. As Gross and others see it, the real problem is that derivatives are now a new way of creating money outside the normal central bank liquidity rules. How? Because they're private contracts between two companies or institutions.

And it takes place outside normal business channels, out there in the "free market." That's the wonderful world of derivatives, and it's creating a massive bubble that could soon implode.

[lostnfound]

5. Fascinating article; but I don't understand how S-Ox fueled a derivatives bubble.

Can anyone explain the inclusion of S-Ox in the list?

Derivatives bubble explodes five times bigger in five years
Wall Street didn't listen to Buffett. Derivatives grew into a massive bubble, from about $100 trillion to $516 trillion by 2007. The new derivatives bubble was fueled by five key economic and political trends:
1.Sarbanes-Oxley increased corporate disclosures and government oversight
2.Federal Reserve's cheap money policies created the subprime-housing boom
3.War budgets burdened the U.S. Treasury and future entitlements programs
4.Trade deficits with China and others destroyed the value of the U.S. dollar
5.Oil and commodity rich nations demanding equity payments rather than debt

[PA Democrat]

6. I didn't get that either.

I'm wondering if credit default swaps became more attractive because they fell outside of the scope of Sarbanes-Oxley? The trading of CDSs and other derivatives have been described as a "shadow banking system" which implies that this activity is not monitored or regulated by any current laws. I wonder how those things show up on a company's balance sheet?