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The Real Reason for the Global Financial Crisis…the Story No One’s Talking About
By: Money_Morning Sep 18, 2008
marketoracle.co.uk
Best Financial Markets Analysis ArticleShah Gilani writes: Are you shell-shocked? Are you wondering what's really going on in the market? The truth is probably more frightening than even your worst fears. And yet, you won't hear about it anywhere else because “they” can't tell you. “They” are the U.S. Federal Reserve and the U.S. Treasury Department, and they can't tell you what's really going on because there's nothing they can do about it, except what they've been trying to do – add liquidity.
At the exchange rate yesterday (Wednesday), 35 trillion British Pounds was equivalent to U.S. $62 trillion (hence, the 35 trillion Pound gorilla). According to the International Swaps and Derivatives Association , $62 trillion is the notional value of credit default swaps (CDS) out there, somewhere, in the market.
This isn't the first time Money Morning has warned readers about the dangers of credit default swaps. And it won't be the last.
The Genesis of a Derivative Boom
In the mid-1980s, upon arriving in New York from Chicago with an extensive background trading options and futures (the original derivatives), I was offered a job at what was then Citicorp [today's Citigroup Inc. ( C )]. The offer was for an entry-level post in the bank's brand new OTC (over-the-counter, meaning not exchange traded) swaps and derivatives group. When I asked what the economic purpose of swaps was, the answer came back: “To make money for the bank.”
I declined the position.
It used to be that regulators and legislators demanded theoretical, empirical, and quantitative measures of the efficacy of new tradable instruments being proposed by exchanges. What is their purpose? How will they benefit the capital markets and the economy? And, what safeguards will accompany their introduction?
Not any more. In the early 1990s, in order to hedge their loan risks, J. P. Morgan & Co. [now JPMorgan Chase & Co. ( JPM )] bankers devised credit default swaps.
A credit default swap is, essentially, an insurance contract between a protection buyer and a protection seller covering a corporation's, or sovereign's (the “referenced entity”), specific bond or loan. A protection buyer pays an upfront amount and yearly premiums to the protection seller to cover any loss on the face amount of the referenced bond or loan.
Typically, the insurance is for five years.
Credit default swaps are bilateral contracts, meaning they are private contracts between two parties. CDSs are subject only to the collateral and margin agreed to by contract. They are traded over-the-counter, usually by telephone. They are subject to re-sale to another party willing to enter into another contract. Most frighteningly, credit default swaps are subject to “ counterparty risk .”
If the party providing the insurance protection – once it has collected its upfront payment and premiums – doesn't have the money to pay the insured buyer in the case of a default event affecting the referenced bond or loan (think hedge funds), or if the “insurer” goes bankrupt ( Bear Stearns was almost there, and American International Group Inc. ( AIG ) was almost there) the buyer is not covered – period. The premium payments are gone, as is the insurance against default.
Credit default swaps are not standardized instruments. In fact, they technically aren't true securities in the classic sense of the word in that they're not transparent, aren't traded on any exchange, aren't subject to present securities laws, and aren't regulated. They are, however, at risk – all $62 trillion (the best guess by the ISDA) of them.
Fundamentally, this kind of derivative serves a real purpose – as a hedging device. The actual holders, or creditors, of outstanding corporate or sovereign loans and bonds might seek insurance to guarantee that the debts they are owed are repaid. That's the economic purpose of insurance.
What happened, however, is that risk speculators who wanted exposure to certain asset classes, various bonds and loans, or security pools such as residential and commercial mortgage-backed securities (yes, those same subprime mortgage-backed securities that you've been reading about), but didn't actually own the underlying credits, now had a means by which to speculate on them.
If you think XYZ Corp. is in trouble, and won't be able to pay back its bondholders, you can speculate by buying, and paying premiums for, credit default swaps on their bonds, which will pay you the full face amount of the bonds if they do actually default. If, on the other hand, you think that XYZ Corp. is doing just fine, and its bonds are as good as gold, you can offer insurance to a fellow speculator, who holds the opinion opposite yours. That means you'd essentially be speculating that the bonds would not default. You're hoping that you'll collect, and keep, all the premiums, and never have to pay off on the insurance. It's pure speculation.
Credit default swaps are not unlike me being able to insure your house, not with you, but with someone else entirely not connected to your house, so that if your house is washed away in the next hurricane I get paid its value. I'm speculating on an event. I'm making a bet.
The bad news is that there are even worse bets out there. There are credit default swaps written on subprime mortgage securities. It's bad enough that these subprime mortgage pools that banks, investment banks, insurance companies, hedge funds and others bought were over-rated and ended up falling precipitously in value as foreclosures mounted on the underlying mortgages in the pools.
What's even worse, however, is that speculators sold and bought trillions of dollars of insurance that these pools would, or wouldn't, default! The sellers of this insurance (AIG is one example) are getting killed as defaults continue to rise with no end in sight.
And this is only where the story begins.
The Ticking Time Bomb
What is happening in both the stock and credit markets is a direct result of what's playing out in the CDS market. The Fed could not let Bear Stearns enter bankruptcy because – and only because – the trillions of dollars of credit default swaps on its books would be wiped out. All the banks and institutions that had insurance written by Bear would not be able to say that they were insured or hedged anymore and they would have to write-down billions and billions of dollars in losses that they've been carrying at higher values because they could say that they were insured for those losses.
The counterparty risk that all Bear's trading partners were exposed to was so far and wide, and so deep, that if Bear was to enter bankruptcy it would take years to sort out the risk and losses. That was an untenable option.
The Fed had to bail out Bear Stearns.
The same thing has just happened to AIG . Make no mistake about it, there's nothing wrong with AIG's insurance subsidiaries – absolutely nothing. In fact, the Fed just made the best trade in its history by bailing AIG out and getting equity, warrants and charging the insurance giant seven points over the benchmark London Interbank Offered Rate (LIBOR) on that $85 billion loan!
What happened to AIG is simple: AIG got greedy. AIG, as of June 30, had written $441 billion worth of swaps on corporate bonds, and worse, mortgage-backed securities. As the value of these insured-referenced entities fell, AIG had massive write-downs and additionally had to post more collateral. And when its ratings were downgraded on Monday evening, the company had to post even more collateral, which it didn't have.
In short, what happened in one small AIG corporate subsidiary blew apart the largest insurance company in the world.
But there's more – a lot more. These instruments are causing many of the massive write-downs at banks, investment banks and insurance companies. Knowing what all this means for hedge funds, the credit markets and the stock market is the key to understanding where this might end and how.
The rest of the story will be illuminated in the next two installments. Next up: An examination of the AIG collapse, followed by a look at how bad things could get, and what we can do to fix the problem at hand. So stay tuned.
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Credit Crisis Truth: The Real Story Behind the Collapse of AIG Credit Crisis 2008
Part II Sep 27, 2008 - 02:09 PM
Best Financial Markets Analysis ArticleShah Gilani: In Part II of his three-story investigation of the credit crisis, Money Morning Contributing Editor Shah Gilani shows us how American International Group, a perfectly sound company that's survived for 89 years, was destroyed by some errant bets on a derivative security called a “credit default swap,” or CDS. It's a story you'll read nowhere else . Editor
There's nothing fundamentally wrong with the core insurance business units of American International Group Inc. ( AIG ). Nothing at all. What imploded the venerable insurance giant was an accumulation of misplaced bets on credit default swaps.
By the best estimates of the International Swaps and Derivatives Association and the Bank for International Settlements (BIS), often referred to as the central banks' central bank, the notional value of credit default swaps out in the market place is some $62 trillion , or 35 trillion British Pounds at an exchange rate of $1.78.
A credit default swap (CDS) is akin to an insurance policy. It's a financial derivative that a debt holder can use to hedge against the default by a debtor corporation of sovereign. But a CDS can also be used to speculate.
A subsidiary of AIG wrote insurance in the form of credit default swaps, meaning it offered buyers insurance protection against losses on debts and loans of borrowers, to the tune of $447 billion . But the mix was toxic. They also sold insurance on esoteric asset-backed security pools – securities like collateralized debt obligations (CDOs), pools of subprime mortgages , pools of Alt-A mortgages , prime mortgage pools and collateralized loan obligations. The subsidiary collected a lot of premium income and its earnings were robust.
When the housing market collapsed, imploding home prices resulted in precipitously rising foreclosures. The mortgage pools AIG insured began to fall in value. Additionally, the credit crisis began to take its toll on leveraged loans and it saw mounting losses on the loan pools it had insured. In 2007, the company was starting to feel serious heat.
From its humble beginnings in China in 1919 – through the 40-year tenure of CEO Maurice R. “Hank” Greenberg , which ended ignominiously for Greenberg in 2006 – AIG grew aggressively. Greenberg grew and diversified the insurance giant, ultimately amassing a trillion-dollar balance sheet.
But not everything was Kosher .
In an effort to assuage analysts and maintain leverage, the firm entered into sham transactions to affect the appearance on its balance sheet of $500 million of loan-loss reserves, which analysts had been questioning as formerly declining. The result was a 2006 Securities and Exchange Commission enforcement action , a $1.6 billion settlement and the removal of Greenberg. Greenberg is still fighting civil charges related to his actions at the firm.
As 2007 progressed, so did the losses on AIG's books and credit default swaps. Once again, it appears that AIG tried to “manage” the problem through accounting maneuvers. Last February, for instance, AIG said that “its auditor had found a material weakness in its accounting.” It had not been properly valuing its CDO liabilities and swap-related write-downs. The losses were revealed to be in excess of $20 billion through this year's first quarter. The SEC is once again investigating, as are criminal prosecutors at the U.S. Justice Department and the U.S. Attorney's Office in Brooklyn.
After writing down assets against gains elsewhere, AIG posted cumulative losses of $18 billion over the last three quarters. In February, AIG posted $5.3 billion in collateral against credit default swap contracts it had written. In April, AIG had to post an additional $4.4 billion in collateral. When rating agencies Standard & Poor's , Moody's Investors Service ( MCO ) and Fitch Ratings Inc. , lowered the firm's ratings last Monday evening, it triggered an additional $14 billion collateral call as margin against AIG's credit default swaps.
The company didn't have the cash.
Indeed, the dire need for cash collateral on top of mounting losses on warehoused CDO “assets” on the company's balance sheet necessitated a massive infusion of capital. That's what happened to AIG.
But once again, there's the story – and there's the story behind the story.
There's a problem – an inherently systemic problem – and it has to do with how structured investments like tranched collateralized debt obligations (CDOs), residential mortgage-backed securities (RMBS), commercial mortgage-backed securities (CMBS), and credit default swaps on them and on corporate debts and loans are actually valued.
Individually, CDOs are hard to value. Suffice it to say, legend has it that constructing the cash flow payments on the first theoretical 3-tranche CDO (the simplest type of CDO) took a Cray Inc. ( CRAY ) supercomputer 48 hours. Now try and value credit default swaps on them!
Because there are so many different individual CDO securities, and because there are so many credit default swaps on so many of these CDOs, and so many swaps on individually referenced entity debts and loans, the only way to value them in a portfolio is by indexing.
That's right, there are indexes, and guess what? You can trade the indexes! Markit Group Ltd. , of London, constructs and manages the CDX, ABX, CMBX and LCDX family of credit-default-swap indexes. Investopedia has a decent little tutorial .
Here's the problem: If you own a portfolio of CDOs, and the only way to value them (or, at least, to develop a valuation that others are reasonably certain to respect), is by looking at them through the prism of an index of credit default swaps on them, you're at the mercy of the index. Your portfolio, your securities may not be so bad, but you may not really know based on mortgage-duration analysis and foreclosure events that you can't calculate. So you value, or mark-to-market , against the closest index.
Here's the rub. What if other speculators are selling short – that is, betting in anticipation of that index going down? What if large portfolio-hedgers are selling short the index to hedge the portfolio they can't sell because no one will buy it – because no one knows what it's worth?
It's crazy. And it gets worse.
What if you're running a profitable company that needs to borrow money, but credit default swaps (bets against your ability to pay back your debt) are expensive by virtue of speculators fear and greed, such that if any bank looks at where the CDS pricing on your paper is trading, they tell you: “Sorry, but we can't lend you money because the market for credit default swaps thinks you're a bad bet.”
You don't get the loan. You can't build your factory; you can't produce and have nothing to sell. The upshot: Now you actually are going out of business. Is this self-fulfilling?
Ponder this: Last Monday, as AIG was initially seeking $20 billion in capital and actually had it in hand (by virtue of a deal with New York insurance regulators), traders were bidding up credit default swaps on AIG's debt and loans so furiously that based on the insurance premiums traders were actually paying for default insurance on AIG… the company was already dead . Self-fulfilling?
Credit default swaps are creating a downward spiral in the capital markets, driving up the cost of capital, and squeezing out all manner of borrowers. And these speculative bets run amok are undermining all U.S. Federal Reserve and U.S. Treasury Department efforts to “liquefy” the system. If this keeps up, the credit default market could sink the U.S. economy into a recession/depression that will make the Great Depression look like a day at the beach.
Anyone got a towel?
[ Editor's Note : Contributing Editor R. Shah Gilani has toiled in the trading pits in Chicago, run trading desks in New York, operated as a broker/dealer and managed everything from hedge funds to currency accounts. In this special three-part investigation, Gilani draws upon the experiences and network of contacts developed from his time as a professional trader and hedge-fund manager to provide Money Morning 's readers with the “real story” of the credit crisis . |
