Credit Default Swaps: Evolving Financial Meltdown & Derivative Disaster Du Jour

[Joanne98]

by Dr. Ellen Brown
Global Research, April 11, 2008
www.webofdebt.com/

When the smartest guys in the room designed their credit default swaps, they forgot to ask one thing - what if the parties on the other side of the bet don’t have the money to pay up? Credit default swaps (CDS) are insurance-like contracts that are sold as protection against default on loans, but CDS are not ordinary insurance.

Insurance companies are regulated by the government, with reserve requirements, statutory limits, and examiners routinely showing up to check the books to make sure the money is there to cover potential claims. CDS are private bets, and the Federal Reserve from the time of Alan Greenspan has insisted that regulators keep hands off.

The sacrosanct free market would supposedly regulate itself. The problem with that approach is that regulations are just rules. If there are no rules, the players can cheat; and cheat they have, with a gambler’s addiction. In December 2007, the Bank for International Settlements reported derivative trades tallying in at $681 trillion - ten times the gross domestic product of all the countries in the world combined. Somebody is obviously bluffing about the money being brought to the game, and that realization has made for some very jittery markets.
http://dandelionsalad.wordpress.com/2008/04/11/credit-default-swaps-evolving-financial-meltdown-derivative-disaster-du-jour/

You know what this means don't you? It means that these derivatives aren't worth shit. The whole international banking system's worth is just useless paper.

[sharesunited]

1. The Wiki article says only 42.6 trillion.

Still an awful lot.

http://en.wikipedia.org/wiki/Credit_default_swap

[Joanne98]

2. wiki is wrong here's the BIS statement..

The 2007 Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity Report which the BIS is publishing today shows a substantial increase in turnover in foreign exchange and OTC derivatives markets. Turnover in traditional foreign exchange markets increased by 71% between April 2004 and April 2007 to reach $3.2 trillion. The largest contribution to the increase in aggregate turnover was made by growth in FX swaps. Activity in OTC derivatives markets was vibrant in April 2007. Average daily turnover in OTC foreign exchange and interest rate contracts went up by 74% relative to the previous survey in 2004, to reach $4.2 trillion in April. Notional amounts outstanding went up by 135% to $516 trillion at the end of June 2007 and gross market values of OTC derivatives, which refer to the cost of replacing all open contracts at the prevailing market prices, increased at a considerably lower rate (74%) than notional amounts during the reporting period, to $11 trillion at the end of June.
http://www.bis.org/press/p071219.htm


$516 trillion

That's less than the above piece. maybe it's gone up since then. This report is dated Dec 2007

[flashl]

3. The $681 trillion iceberg no one want to see, they haven't found a way to blame it on the consumer.

[slipslidingaway]

4. Notional values and actual dollar values...

From February 2000

http://contraryinvestor.com/moarchive2000/mo020300.htm

"Update Time...In fact, quite timely, really. Surely with the volatility in the bond market these days, it's high time we checked in on those wacky money center banks and their highly flammable derivatives exposure. All sarcasm aside, the reason we continue to update you each quarter on these numbers is that derivatives are part of "what's different this time". In 1990, the total notional value of derivatives outstanding "off" the balance sheet of the commercial banking system in the U.S. was $6.2 trillion. As of 3Q 1999 (the latest numbers released), the value has skyrocketed to over $35 trillion. Needless to say, the number is quite significant. See what we mean?

....Let's get one thing straight, one must draw a clear distinction between notional values and actual dollar values. The whole premise of derivatives transactions is that a few real dollars can be spent to control a large amount of notional dollars. Hence the leverage..."


Printed in the American Almanac, September 6, 1993

http://american_almanac.tripod.com/derivcw.htm

"...In futures trading, the ``notional principal amount'' refers to the value of the underlying assets in a futures contract. For example, in a corn futures contract to take future delivery of 5,000 bushels three months hence, the notional principal amount of the contract would be the price of a bushel of corn times 5,000. If the price of corn were, for example, $2.00, the notional principal value of the corn futures contract would be $10,000. But the actual price of the contract, however, is the margin set by the exchange; the CBOT, for example, requires $270 be paid to purchase a futures contract that on May 15 had a notional value of $11,637.50..."

Another snip...

"...With what are now called derivatives, we move from investment, and purchases and sales of hard commodities, to speculating on the future price or yield performance of what were once investments, and relatively simple, economically necessary transactions. It would be like going to the horse races to bet, not on the race, but on the size of the pot. Who would care about what's involved with getting the runners to the starting gate?..."


Above links and others posted here

1993 and 2000 Derivatives articles...Who could have known???

http://www.democraticunderground.com/discuss/duboard.php?az=show_mesg&forum=389&topic_id=3098855&mesg_id=3099613



And some discussion on the 4/3/08 Stock Market thread

http://www.democraticunderground.com/discuss/duboard.php?az=show_mesg&forum=102&topic_id=3253766&mesg_id=3253766

[slipslidingaway]

5. US banking exposure, global banking exposure, notional vs. cash

Many different numbers...

see link for tables
http://contraryinvestor.com/2008archives/momar08.htm

"...A few more quick facts investors need to keep in mind as we move ahead. First, what we saw above was US banking system exposure. And we only received a glimpse of the big-daddy US commercial banking players. How about a broader view of life? For in the Fitch credit derivatives report, a few other names are thrown around as being concentrated players - Goldman, Duetsche Bank and Morgan Stanley. Luckily the BIS (Bank for International Settlements) reveals what they believe to be numbers for the global CDS market every half year. The history of which is as follows:


...Trajectory, growth, rhythm and magnitude of global credit derivatives expansion is quite like the character we observed above for the US banking system proper. In three short years, global CDS exposure has increased roughly nine-fold. We're talking about close to $45 trillion of credit derivatives on a notional basis. The BIS kindly estimates a gross cash market value for this exposure at $700 billion.

...Remember, in a relatively low yielding macro financial market environment, securities offering above average yield, regardless of the history of credit default cycles or credit spreads, were being coveted by the hedge fund and other assorted levered investment community as if they were manna from heaven. No problem with the credit issue, right? Simply insure these low quality credits within the CDS complex and sleep the night away unperturbed. And that's exactly what happened..."

[slipslidingaway]

6. Bear Stearns and JPM

Wagging The Dog

http://contraryinvestor.com/mo.htm

April 2008

"...Alright, fine, so how does the credit default swap market relate to equity market sector volatility of the moment? It is absolutely clear that the "acquisition" of Bear avoided triggering Bear Stearns related credit default swaps and swaps against CDO, SIV, etc. positions they may have held (assuming a potential Bear BK would have forced a mark to market event), which would indeed have happened had Bear formally entered bankruptcy and their bonds/debt became potentially very meaningfully impaired. There is simply no question whatsoever in our minds that this was the key reason a theoretical acquisition of Bear HAD to happen. Remember the details. JPM took out Bear for a couple of hundred million at the headline $2 per share initial offer level, but concurrently announced it was going to need to charge off about $6 billion as a result of the so-called acquisition. Even at the ultimate $10 level (which is basically shut up money offered to help prevent litigation, which might also have led to asset price discovery) JPM was "telling" us Bear was worth far less than zero by the charge-off number alone. Of course the truth simply had to be that if Bear had filed bankruptcy and the credit default swaps written against their bonds/debt/asset positions had been triggered, the credit default swap liabilities in the market would have been well north of a $6 billion hit to whomever had written those Bear specific CDS contracts. Well north. And that simply could not have been allowed to happen. By the way, just as an item of curiosity, JP Morgan has exposure to over 55% of the total banking system credit default swaps outstanding. Are we connecting the dots clearly enough for you?..."