The derivatives bubble. Bailing out those that abused and created it.

In 1997, JP Morgan created the little known "Credit Default Swap" or CDS as a device that allowed lenders to free up capital otherwise restricted by federal regulations. Federal law required banks to hold large cash reserves to insure investments, should they go bad. JP Morgan created CDS's as a far less regulated way to shift insurances to a third party. This would then free up insurance reserves allowing increased investment capital.

Credit default swap From Wikipedia,
A credit default swap (CDS) is a credit derivative contract between two counter parties. The buyer makes periodic payments (premium leg) to the seller, and in return receives a payoff (protection or default leg) if an underlying financial instrument defaults.CDS contracts have been compared with insurance, because the buyer pays a premium and, in return, receives a sum of money if one of the specified events occur.

However, there are a number of differences between CDS and insurance, for example:
* the seller need not be a regulated entity, this, perhaps, increases counter party risk,
* in the United States CDS contracts are generally subject to mark to market accounting, introducing income statement and balance sheet volatility that would not be present in an insurance contract, and
* generally Hedge Accounting is not available under US GAAP, this also increases income statement and balance sheet volatility.

The buyer of a CDS does not need to own the underlying security or other form of credit exposure; in fact the buyer does not even have to suffer a loss from the default event.[2][3][4] Generally, to purchase insurance the insured is expected to have an insurable interest such as owning a debt.

With a booming market and a loosely regulated scheme freeing up capital, CDS's were the hot ticket. In no time at all this resulted in $trillions of flimsy insured investments that creating a ticking time bomb for the world economy. These privately traded derivatives contracts went from zero to $54.6 trillion in just over a decade! Should there be widespread failures we now had nothing substantial in place to back them up.


money.cnn.com...

What makes this bad is that many huge firms are attached to one another through CDS's. By the time AIG was bailed out, it held $440 billion in credit default swaps. Lehman Brothers had made more than $700 billion worth of credit default swaps, many of them backed by AIG. Wachovia and Citibank recently tangled in court over $10 billion in credit swaps. At the time it filed bankruptcy, Lehman Bros. had around $155 billion of outstanding debt, but around $400 billion notional value of CDS contracts had been written that referenced this debt. You can only imagine how many CDS's will be related to Freddie Mac and Fannie Mae?

These companies should sound very familiar? They were all front and center to receive bailout funds. This is directly due to them abusing the monster created by JP Morgan, [also given a handout], called Credit Default Swap.

The Bank for International Settlements recently reported that total derivatives trades exceeded one quadrillion dollars - that's 1,000 trillion dollars -roughly about 17 times the gross domestic product of all the countries in the world combined.

This equates to a derivatives bubble that is, without a doubt, the mother of all bubbles! This thread is the last in a series of threads I have written here at ATS. I've tried to stir debate about credit reform, commercial loan bubble, bailout unfairness and now the derivatives bubble. To my surprise they have not attracted as much attention as I thought they would, but I'll keep trying? Please give this some thought. While it may not be as exciting as rocks on Mars or the end of the world, it's important that we are all treated equal. That we demand fairness and justice, and at very least, we know and understand what's going on around us.




en.wikipedia.org...
hubpages.com...
en.wikipedia.org...

I've heard a lot about these over the last few months, but when is this bubble going to burst?

Will it be a slow trickle or a huge bang?

Originally posted by dingleberry77
I've heard a lot about these over the last few months, but when is this bubble going to burst?

Will it be a slow trickle or a huge bang?

That is hard to say due to these being contracts and quick deals? Being outside of regulations, you never know how deep the problem runs for whom? Bailouts and market manipulations are symptoms of the point of no return! It's happening now, so I would guess it will play itself out entirely this year? Not a slow trickle or huge bang, just steady.

I used to work for a company that traded heavily in S&Ps and the DOW and I still don't really understand what they were trading

reply to post by Zerbst


Well I would suppose by looking at the numbers that something is horrifically wrong with the picture.. outstanding debts to world GDP that is..

I really don't know much about the nature of CDS's.. I suppose one way you could paint a clear picture for me .. is to explain the following:

When a company defaults on the debt, exactly what happens? And more specifically, what happened to the outstanding CDS's from bought out firms like Washington Mutual, or nationalized entities like Freddie Mac/Mae, and Lahmen Brothers?

Detailing this to me, imo, may shed a brighter light on the dangers we face..

Our "stimulus and bailout" packages look pathetically tiny compared to such massive debts..

Also, a company purchasing these debts I would assume means they are buying the "insurance" that should it be needed, they have the reserves on hand in ratio to their exposures.. this would mean then they every major financial institution has leveraged themselves far beyond their actual cash reserves would allow? .. For instance, it would not be impossible for Citibank to be leveraged 280x-it's own cash reserves?

And, allowing that this is true (to which these are all guesses, again I don't know anything about these instruments) I would have to speculate as to what exactly the banks where leveraging their funds for? .. If you add all the sub-prime commercial and residential real estate .. it doesn't come close to touching the numbers being shown..

Your insight?

reply to post by Rockpuck


These are contracts rather than traditional securities, like bonds. The bank normally backing a loan would hold reserves of equal value to protect itself from default. CDS contracts allow the bank to sell off it's security requirements to a third party. This third party investor, unlike the bank, needs only to pay a determined monthly installment over a certain period of time. This third party is speculating that said secured loan will default in this period of time. If so, the bank will pay a determined amount to third party. If no default occurs in that period, bank will collect third parties installments as profit while also securing loan.

These deals are open to anyone to make. They are also shifted and split numerous times during speculation. The trouble only surfaces when, like current conditions, widespread failures are seen throughout the market. Then the absence of full security insurances can be devastating. When these loosely regulated terms cannot be met, once unforeseen, risks begin to multiply. A vicious chain reaction can occur leaving very little protection to $ trillions in investments.

Many more loans were created from this device alone. It compounds the problems in that it allows freed up capital once used for investment security to create many more loans due to its new availability. This will be unavoidable when it begins snowballing! I feel that soon the commercial loan bubble will hit followed by this? That is when everyone will understand how bad things really are!

someone asked...How long will this CDS bubble last?


I'd say that the current CDS bubble will continue to stay intact,
and new contracts issued,
as long as these CDS' are sequestered/hidden on off-balance sheets
or never monetized as only a tiny, tiny fraction have been at the Fed Reserve swap window.



The Fed & Treas. have a good idea that all those former 'Primary Dealer'
banks & firms which already sucked up the known Billion$ in bailout $$'s...

& the unknown Trillion$ via obscure Fed 'facilities' 'windows' and other
liquidity providing programs to the likes of JPM, GS, Merrill, AIG, BoA
& a host of other institutions.


The bubble may start to deflate when the Treasury along with the Fed
unveils their plans today (tues 10 feb) on how the bank reforms will work.
Geithner might start to monetize some of these derivatives/CDS' and not others' if industry analyists are somewhere near correct in their outlook that the reforms may include some of the following:

Here's the basic approach:


* The US Treasury would tender for all of the private label CDO/MBS extending between a range of dates, say 2004 forward to year-end 2007, representing trillions of dollars in assets held by investors and banks globally. The pricing on this paper will reflect current market prices, but say the average price was 50% of face value. Only issues that actually have an enforcable legal claim to collateral will be eligible. Derivative structures without collateral will not be eligible.


* Treasury then transfers all of the purchased toxic paper to the FDIC Deposit Insurance Fund, which acting as receiver under 12 USC restructures the trusts that are the legal issuers of the bonds and recovers legal ownership of the underlying collateral. The FDIC arguably has the power to call in all bonds and related investment contracts, and extinguish the claims of those parties which do not respond to the Treasury tender. The legal finality of an FDIC-managed receivership under 12 USC is what is required to end the toxic asset issue once and for all. The bankruptcy courts could be used in a similar fashion, but the unique legal authority of the FDIC suggests to us that this agency should run the process as part of its larger asset sale operations.


* This now "clean" whole loan collateral will then be re-sold to solvent banks in the localities where the property is located, using zip codes and other means to identify eligible buyers, priced at say 90 cents on the dollar, with a full recourse guarantee from the FDIC and financing from the Federal [...]

the bold & underlined is what will either deflate or burst the derivatives bubble... Interest Rate Swaps & Credit Default Swaps are just two of the financial WMDs...
source: us1.institutionalriskanalytics.com...


we'll see how it goes today...





Oh, btw, there's a link to "CDS explained" near the bottom of page
in response to the Rockpuck request

with some details of the plan being announced it looks like the gov't will try to use large leverage AGAIN (that worked right!) to start with a couple hundred billion in seed money to intice private investors to find a price that they are willing to pay and that banks are willing to accept. finding that price may be difficult because banks have BEEN RATHER happy sitting on these toxic debts in a game of "don't ask don't "sell" to avoid price discovery of say 30 cents maybe 50 cents on the dollar. Geithner says he want price discovery so lets see what price is paid. The gov't is going to limit the private investors losses which may get someone to bite and thus pay what a bank will be willing to off-load them for (more than there current 30 cent of the dollar price)

ST udio what is your take on this bank plan........notice the market cap of the banks is a fraction of the potential losses on there tier three assets and/or (off balance sheet trash) the potential for losses on assets is well into the trillions.

reply to post by Zerbst


To the naive and under-educated taxpayer it would appear that both the buyer and seller of CDSs would be in a position to recognize the risk of such an arrangement. The buyer must have realized the cost was too low and the seller had to know that they could not perform in a less than ideal scenario.

So the motivation must be to hide the risk of inadequate reserves from the prying eyes of regulators. Do that when you're borrowing money from a bank to buy a house and they'll call it fraud!_javascript:icon('')