Credit Default Swaps, Wall Streets Worst Invention Ever

By: Money_Morning

Martin Hutchinson writes: When it comes to naming a winner in the competition for “the worst product ever invented by Wall Street,” there is quite a list of worthy candidates. With just the current financial crisis alone there are such “inventions” as subprime mortgages, auction rate preferred stock and asset-backed commercial paper, which all have a good claim to this title.

There's also the credit default swap (CDS).

While credit default swaps remain in second place to subprime mortgages in terms of total losses caused, there are plenty of reasons to crown these derivative securities as Wall Street's worst offenders ever.

It won't take me long to make my case. In fact, for “Exhibit A,” let's just look at the collapse of U.S. insurance giant American International Group Inc . ( AIG ).

Misguided Missile

On Monday, the government announced that the already-hard-pressed U.S. taxpayer is being forced to put another $30 billion into AIG , bringing the total rescue package, thus far, to $180 billion.

For those with short memories, by far the largest portion of AIG's losses has come in the $50 trillion credit default swap market, which was instituted only in 1995. Other Wall Street products have caused huge losses, but have spent decades growing before they did so, producing sober profits for many years before blowing up.

[Just yesterday (Tuesday), in fact, U.S. Federal Reserve Chairman Ben S. Bernanke verbally ripped AIG - saying the insurer operated like a hedge fund, while stating that having to rescue the insurer made him "more angry" than any other episode during the financial crisis - because of how its mishandling of credit default swaps led to the company's implosion.]

It is increasingly clear that CDS's have produced profits only for the dealing community, and only for a few years. Even by Wall Street's abominable standards, they thus have a rightful claim to be considered the worst financial “product” ever invented.

Under a credit default swap, if Institutional Investor “A” has a $10 million loan to Megacorp, Institutional Investor “B” can agree to cover the credit in that loan. In other words, if Megacorp defaults, “B” has to cover the debt. But “B” collects a small insurance premium for agreeing to cover the loan - a premium it gets to pocket as income.

Typically, payments under a Megacorp CDS are triggered either by a bankruptcy or by Megacorp failing to pay interest or principal on its debts. Because hedge funds and others gamble with these financial instruments, the problem arises in that the volume of credit default swaps currently outstanding is far greater than the volume of the loans themselves.

The bottom line: The credit risk spawned by the CDS market is much larger than the credit risk of loans on which CDS are written.

It's no longer a question of hedging. It's casino capitalism.

Inside View From an Insider

Back in the early days of the derivatives market, I spent five years running my employer's derivatives desk: It was very simple stuff - mostly small transactions - and while we made money, the trades didn't make either us or our employers rich.

However, we were always on the lookout for something new, because you can make good money on new types of transactions - without taking big risks. Needless to say, we looked at the possibilities of credit derivatives, for which there was an obvious need among the major international banks.

But there were two problems:

• First, there was no obvious way of settling the things - each bankruptcy is unique, and the generally happen gradually, so it was difficult to determine how much to pay and when to pay it.
• And second, the cash flows involved were totally skewed - a small annual payment versus the possibility of a huge payout on bankruptcy - so the amount of credit risk you'd build up between the two sides made the whole business uneconomic if you allocated risk correctly.

By the middle 1990s, the capital markets were so exuberant that dealers didn't bother to solve those problems - they just ignored them. A $50 trillion credit derivatives market means there is $50 trillion of credit exposure on the dealer community, and no amount of collateral arrangements and fancy accounting can eliminate that fact. As for settlement, the dealers came up with an ingenious, but very un-foolproof scheme, whereby a mini-auction of the bankrupt credit would take place, so by buying a million or two in dodgy bonds you could corrupt the pricing of billions in credit default swaps that you held.

There are two other problems with credit default swaps CDS we didn't think of in the 1980s.

First, AIG stayed almost entirely on one side of the CDS market - selling credit protection - because it believed it could do so, book the premiums up-front as income, collect bonuses based on the total premiums each year and never account for the risks on the actual derivative contracts themselves. After all, the swaps were being AAA-rated mortgage backed bonds.

It would never have occurred to us in the 1980s that we could do this - we weren't sufficiently in control of our auditors!).

From the point of view of AIG, the company, this was extremely stupid, though it had its advantages from the traders' point of view. In the end, of course, it was all of us - the U.S. taxpayers - who were stuck paying the tab for a meal that others got to eat.

However, the second - and most serious - problem with credit default swaps is their potential use by short-sellers to cause bankruptcies.

Short-Sighted, Short-Selling

In the so-called “rational markets” that are so beloved by the textbooks, this should theoretically be impossible. In the real world, however, it would be fairly easy to engineer - especially in a period of uncertainty, such as we have had since 2007 - for a large operator to spread rumors, push down share prices, and thus cause the market to panic.

Richard S. “Dick” Fuld Jr. , the former chief executive officer of Lehman Brothers Holdings Inc. (OTC: LEHMQ ), the former CEO of Lehman, is convinced this is what happened in Lehman's case , and it has undoubtedly been tried in several others.

Short-selling of shares was banned for several weeks after the Lehman bankruptcy , the reality is that neither short share sales nor share put options offer anything like the potential of credit default swaps to profit from a bankruptcy - particularly the bankruptcy of a financial institution whose debt is several times its share capital. Citigroup Inc. ( C ) and JPMorgan Chase & Co. ( JPM ), for example, each have around $1 billion in short positions outstanding in their shares. In the traded options market, Citigroup has a nominal $1.4 billion worth of put options outstanding while JP Morgan Chase has $2.1 billion - the cash value of those contracts will be a fraction of those figures.

What's more, there are undisclosed amounts of over-the-counter equity options written between dealers. However, the volumes of credit default swaps were recently $65.7 billion on Citigroup and $62.4 billion on JPMorgan.

Now think about the arithmetic. To sell a share short, you risk all your capital - there's no limit on how high a share of stock can rise. To buy puts, you deal only in a small market, and most puts are short-dated, so you would have to act quickly. With a CDS, however, you pay only an annual premium that is a small fraction of the principal amount involved, you acquire an asset that typically lasts several years, and you can deal in a market of over $60 billion - enough potential profit for even the greediest hedge fund.

Thus, credit default swaps make causing a “run” on a bank or investment bank enticingly profitable, with a profit potential that far outweighs the cost of undertaking the operation. Because the CDS market is much larger than the market for stock options - or even the share markets themselves - the product is a standing temptation to bad guys, and a danger to the banking system.

By now, it's easy to see why credit default swaps are Wall Street's worst invention.

Granted, these particular derivative securities are so far only second in total losses, behind subprime mortgages, but they lack the social purpose of the home loans for borrowers with poor credit, since those mortgages at least had the somewhat redeeming benefit of putting some folks in houses.

While there are a few CDS securities that genuinely hedge credit risk, almost all of them have no such benefit: They are gambling contracts, pure and simple.

For the taxpayer to bail out the victims with self-inflicted CDS wounds is as ludicrous as asking us to bail out the Las Vegas casinos.

But don't laugh - that may well happen, yet.

[ Editor's Note : When it comes to either banking or the international financial markets, there's no one better to hear it from than Money Morning Contributing Editor Martin Hutchinson , for he brings to the table the kind of high-level expertise that our readers have come to expect. In February 2000, for instance, when he was working as an advisor to the Republic of Macedonia, Hutchinson figured out how to restore the life savings of 800,000 Macedonians who had been stripped of nearly $1 billion by the breakup of Yugoslavia and the Kosovo War.

Credit default swaps entered the public lexicon last September , with the collapse of insurer American International Group Inc. But in an article featuring the headline, " Credit Default Swaps: A $50 Trillion Problem ," Hutchinson warned Money Morning readers back in April 2008 that these derivative securities were poised to cause big problems for investors.

Just last month, Hutchinson published an analysis on the "Top 12 U.S. banks" report . If you missed story, which enjoyed a big response when it was published last Wednesday, please click here to access it and check it out. The report is free of charge. The follow-up story on that story was his analysis of Fifth Third Bancorp ( FITB ). The report on Fifth Third appeared last Friday . Both reports may be well worth your time to read.

Hutchinson also writes regularly for our monthly newsletter, The Money Map Report , in which he and other Money Morning colleagues also make investment recommendations for subscribers. To find out more about The Money Map Report - including a special offer that includes The New York Times best seller, " Crash Proof " -  please click here . ]

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