Monday, February 7, 2011

Credit Default Swaps

Leveraged trading.. which in many ways is simply gambling.. has been around for quite some time here in the US. . Every day in America, people bet on sports teams without actually owning part of them. "Bucket Shops" as they were called, were essentially gaming establishments.. only instead of the Yankees or the Red Sox, they were betting on a stock.. GE, US Steel, etc.. without actually owning the stock. They were essentially side bets. During the early part of the 1900's, Edwin Lefevre ran one such shop on behalf of the legendary Jesse Livermore. Worse, in these bucket shops, people were buying on margin. For example, if you wanted to bet $1,000 that GE was going up to $65 a share, you would only have to lay down $100. Of course if you were wrong, you owed the bucket shop bookie the other $900. All of this without actually owning any stock.. it was, at it's heart, gambling. These bucket shops became so pervasive that they actually began, through inside information, to affect the actual stock prices.. and this was what in large part led to the "Panic of 1907", where the NYSE lost more than 50% of it's value from the high in 1906. The "Bucket Shop Laws" were enacted by Congress shortly after the Panic.

Fast forward three quarters of a century and we're in the partying 1980's.. the last days of Bill Clinton's presidency to be exact. Alan Greenspan, the Fed Chairman, has become very, very powerful as prosperity grips the nation, with many giving Easy Al the credit. Among those who believed Easy Al was Clinton himself. As his Presidency was coming to a close, Greenspan championed a bill in Congress, HR 5660, called the Commodity Futures Modernization Act, written by a Republican Congressman from Texas on behalf of Goldman Sachs.. He touted it as a necessary further step in the deregulation of Wall Street. It was on the last day of the last lame duck Congress that this bill came up for a vote. In their haste to pass it, the Democrats simply wrapped this bill into an Appropriations Bill, who's passage is a given. The appropriations bill was passed on a "unanimous consent".. ie.. everyone was so anxious to get home for the holidays they did'nt even bother with a formal vote. Clinton signed it into law on New Years Eve. The Commodity Futures Modernization Act allowed for Credit Default Swaps (the new term for bucket shop side bets) to become legal again. Worse, the CFMA expressly forbade any governmental agency, local or federal, to either regulate or halt it. Unknown to Greenspan, Clinton or the bill's authors, they has just unleashed the worst financial crisis in mankind's history, one which has yet to be fully played out.

Instead of betting on the Yankees or even Ford Motor Co, unemployed mathemeticians took this craft to new and unimagineable levels. They were initially sold as insurance policies. Here's an example: JeffBank has $10 million in the vault.. and of this $10 million, a million of it is yours, and it's in the form of a 5 year Certificate of Deposit (CD), therefore you cannot simply go into JeffBank tomorrow morning and get your money out.. you have to wait the five years. Now lets say you were getting nervous about JeffBank.. and thus your million dollars. Therefore you want some form of insurance on it, and so you then turn to "JaneBank" (which also has $10 million in the vault), who agrees to write you an insurance policy on this million dollars.. so long as you pay JaneBank a monthly premium. So far, this is legitimate business. But free from regulation, JaneBank then turns to you and says "If you really think JeffBank is going down, we'll write you a $20 million insurance policy, so long as you make the monthly premiums".. even though they only have $10 million in the bank. These are called "naked" Credit Default Swaps.. and are essentially a side bet. Despite not being able to cover their bets, profits at JaneBank are exploding thanks to the monthly premiums they're collecting.. as are CEO bonuses. Today CDS's are written on everything under the sun.. Greek Government Bonds, City of Detroit Bonds, stocks.. everything. The biggest banks in the US.. CitiBank, JP Morgan, Chase, Bank of America.. are so unimagineably head over heels with CDS's it literally blows the limits of imagination. It makes the problems of JaneBank look like kindergarten. Here's an example of just how bad things are: Bank of America, which has deposits of about $825 billion in deposits, has underwritten CDS's for $48 trillion. Yes Trillion. The entire US economy is only $15 trillion. JP Morgan is the worst.. they guarantee $75 trillion. The entire world economy is $50 trillion. As a whole, US financial institutions have underwritten about $225 Trillion in CDS, guaranteeing everything under the sun.. including each other. So if one big financial institution goes down, they are likely to take a number of others with them. This is exactly what happened on September 18th 2008, when Lehman Bros was allowed to go under.. and instantly made AIG insolvent. The US Government immediately stepped in to save AIG. The street rumor was that if AIG had gone down, it would've taken down Switzerland's largest bank (UBS) and Germany's largest bank (DeutcheBank). It would've been financial armageddon. The biggest CDS these days are written on interest rates. If the US Ten Year Bond goes from it's current 3.65% to 7%, the CDS's this will trigger could crash several very large banks.. which would then crash yet more banks. The Domino Effect on steroids.

So now that we know the problem, has the Obama Administration done anything meaningful to halt this insane cancer ? The Frank-Dodd Reform Act calls for CDS's to be regulated.. but not eliminated. It's yet to happen.. the lawyers are still working on the specifics. Why were'nt they simply eliminated ? This is a question best directed towards your Congressman.. and very likely they will have absolutely no idea what a CDS actually is. By reading this article, you now know more than 3/4's of the US House of Representatives. The banksters who are making bazillions on the profits from these highly dangerous devices.. and who are giving Congressmen millions in "consulting fees" and "campaign contributions".. are banking on Congressional ignorance and silence.. and they're getting it. Thus do civilizations collapse.


  1. Mr. K what a great synopsis of the issue. Buffet coined the phrase financial weapons of mass destruction. Do you think that if a scenario were to light the fuse it might actually give us a chance for a reset of the entire system? To bankrupt the banksters that hold all thr reins of power might free us from the debt based system we live in. Just a thought could create chaos and I wouldn't advocate that

  2. In my very humble opinion, debt and CDS's alone will do the job. Not sure what event will light the fuse, but when it goes, there will be no more rescues. It'll melt down within days, and the vast majority of people in the US will never see it coming. One day they'll hear on the news about problems on Wall Street and two days later the ATM's wont work, the gas stations will be closed and when they turn on their radio news stations they'll be told that martial law has arrived.

  3. Anon I hope you are wrong, but I fear that you will be proven correct. In April I won't need gas anymore and I won't need ATMs. However, I will need the banks to reopen to get to my PMs. I just don't think it will happen. I could be in denial. I keep plenty of food on hand to last months and coins for exchange. I do not keep a lot a cash as I am afraid cash will become worthless if we see hyperinflation.

  4. Bankers,like dictators,have their hordes. Collapse will send them scurrying for their bunkers. Everything electronic will cease to exist. They're PM's will be with them in their bunkers. Will your's be with you.

  5. Thanks for the explanation. Very helpfull.

    G. Kowalczyk

  6. Very well done article. I would take issue with one point: that the financial disaster created by the CMFA was unleashed unknowingly. The fact that the Act expressly forbade the enforcement of state and local ordinances prohibiting what amounted to a high stakes shell game without benefit of a pea, is a clear indication that the action was taken with full knowledge of its potential consequences.

    The shell game is still being run by financial institutions whose bailouts have cost the taxpayers hundreds of billions of dollars to date. It will continue until the electorate becomes engaged enough repudiate the current political parties, (including the Tea Party, whose purpose appears to be a combination of entertainment and misdirection) and effect real change at the polls.

    Articles like this one make a significant contribution to that end. Many thanks.

  7. Your article says "1980s" but it should be 1990s. Clinton's first term started in 1993 and ended in 2001.

  8. MOE, have you seen this video from MarketSkeptic? He talks about bucket shops in one of his videos which got me curious about what others were saying. which brought me here.

    Anyway, he posted this yesterday:

    Eric claims that the Fed (or the Treasury - which is which these days?) is planning to issue "put options" on long term Treasury bills. We are hosed bigtime if that is true, if we weren't hosed already by outstanding CDS instruments and unfunded government eentitlements.

    As he describes it, CDS = put options = several other terms I can't remember.

    I am going to post this blog link on his page. Great work.

  9. MOE should be MOI. As in, "Le blog, c'est MOI!"

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