Falling Shoes and a Reader’s Question

A reader has asked about the potential damage to our global economic system from another “derivative” financial product (beyond the mortgage-back security we have already talked about) – a credit default swap (CDS) instrument. In this strange derivative, the buyer makes a series of payments to the seller of the CDS in exchange for an upside upon the occurrence of a specific event (usually a default, bankruptcy, insolvency, or other such carefully defined event), usually tied to the credit risk attached to a specific company (versus, say, an individual mortgage holder).

It’s a bet, but it is also a widely traded instrument in the banking world as a hedge against corporate default (default insurance, if you will), but any seller (CDS issuer) who has to pay the upside on default can truly get tanked if a massive series of defaults occur and lots and lots of payments become due at the same time. CDS instruments are fully tradable securities, bought and sold just like stocks and bonds, and their trading value is based on a complex risk analysis against the value of the income flow, market interest rates and other variables. You pay premiums in good times, get paid off in bad times. Lots of math.

In other words, the CDS market is just another side of the credit default crisis we are seeing in the financial markets, from financial institutions holding lots of bad mortgages to corporate loan defaults. Lots of folks bet that the bad mortgages and bad loans would not be catastrophic and they made money selling this form of default insurance. Lots and lots of profits. The money was good while it lasted, but surprise, surprise, the massive wave of defaults hit, and the call on the CDS sellers was and continues to be massive.

For folks used to trading in fundamental values, these manufactured instruments were and are floating time bombs. Wikipedia noted that: “Warren Buffett famously described derivatives bought speculatively as ‘financial weapons of mass destruction.’ In Berkshire Hathaway's annual report to shareholders in 2002, he said, ‘Unless derivatives contracts are collateralized or guaranteed, their ultimate value also depends on the creditworthiness of the counterparties to them. In the meantime, though, before a contract is settled, the counterparties record profits and losses--often huge in amount--in their current earnings statements without so much as a penny changing hands. The range of derivatives contracts is limited only by the imagination of man (or sometimes, so it seems, madmen).’”

How bad is it? Well this “little market segment alone,” even back in March of this year when the stock market was well over 11,000 (we’re at around 9,100 now), here’s how Time Magazine looked at the problem: “The CDS market exploded over the past decade to more than $45 trillion in mid-2007, according to the International Swaps and Derivatives Association. This is roughly twice the size of the U.S. stock market (which is valued at about $22 trillion and falling [see the note above]) and far exceeds the $7.1 trillion mortgage market and $4.4 trillion U.S. treasuries market, notes Harvey Miller, senior partner at [the New York corporate law firm of] Weil, Gotshal & Manges.”

So in answer to the question as to whether this is the “next” shoe to drop, I have to say that this shoe is off the foot and on the floor. The $700 billion bailout was seen as a drop in the bucket by the global financial markets even as it was signed into law. Bottom line, a lot of financial institutions issuing CDS instruments and companies relying on the underlying “insurance” value will go under, unsalvageable in this meltdown. Others will be saved. And a whole lot of these derivatives won't be called, because the underlying credit will be repaired or really isn't threatened beyond the short-term credit freeze.

But while the government may try and stem the tide of “events of default,” so that many CDS values will not be called, there are limits to what it can do. The government has to focus on saving individual jobs (payroll-related liquidity), stemming the fall of housing values, sustaining and creating jobs and leaving enough solid financial institutions to restart the economy. The resulting consolidation will put an awful lot of power in the hands of fewer institutions. The trade-off has to be vastly superior oversight and regulation.

I’m Peter Dekom, and I approve this message.