I have been trying to find more information before writing this diary, and I will report it in updates if it becomes available. But a post by Atrios triggered me to write now.
I am completely convinced this is all about credit default swap oblgations coming due, and the big banks freaking out about having to pay them.
This will emerge, I believe, as a very sordid story. It is a story of speculators making money off this unregulated instrument, and banks making money off of premium payments to their CDS obligations which vastly outstripped their assets, again allowed for by the lack of sunshine.
The backbreaker for me is this CNBC piece, linked to by Atrios-PIMCO is a financial services company that has heavily bought CDS insurance, and was a big winner in the failure of Fannie Mae and Freddie Mac.
The PIMCO CEO says $700B just won't cut it - we need at least $500B more.
More below the fold.
First, let me say that the PIMCO stakes may be legit. They are probably using the CDS to protect their investments (via mutual funds) in a number of these companies. This is the reasonable intent of CDS - to insure security holders against the failure of their investments.
As noted in Devilstower's excellent frontpager last weekend, the trouble is that there is simply no regulation of these CDS. As a result, these instruments so beloved by Alan Greenspan can be bought by those interested in making money off the failure of securities they do not hold!
But root around on line and you will find that these `naked' buyers of CDS securities now apparently dominate the holdings! Soros suggested as much last spring. I cannot find quantitative information about this - I don't doubt Bernanke and Paulson have it - but here is a quote from an Aug. 10 article by Gretchen Morgensen of the NYT that caught my eye:
Initially, this market was intended to make hedging a corporate bond position easier. But speculators who don’t hold bonds now dominate the market, using the swaps instead to wager on a company’s health or the prospects of a securities portfolio. In Wall Street parlance, these investors would be characterized as trading the contracts "uncovered" or "naked." (emphasis mine).
This explains how the CDS market came to exceed the annual world GDP and how it is many multiples of the existing value of the mortgage securities which are the underlying driver of the problem. If anyone can make a bet on a security, especially when it looks like that security might fail (again, no regulation prevents that) you will get a multiplier of the value of the original securities.
The betting then comes from speculators who if they arrive late put in relatively small premiums compared to the payout that results from failure.
This also suggests that in the case of securities related to potentially failing companies, CDS could provide those with inside knowledge a chance to profit off the collapse. There is in fact a scholarly paper about just that issue with empirical data (skim through the academic literature about CDS and you will discover it is almost exclusively mathematical theorizing about the means to price these `instruments'.)
So clearly there is a strong incentive to speculate in these unregulated instruments.
There is of course the fact I alluded to the other day that the big banks like JP Morgan became the biggest holders of CDS obligations. What did they get? Well, like any insurance holders, they get the premiums in on what they perceive to be low risk investments. And without regulation, there is no need to prove they have the adequate assets to back payouts if the need arises. And hence the total CDS obligation of JP Morgan is estimated at about $8 Trillion!
All those premiums in are pure cash enhancing the banks bottom line if there are no payouts. Speculators want in? Sure, no problem. More premiums, more cash, better stock value, better CEO bonuses!
And now the mortgage meltdown is triggering a need to pay out. And there is simply NO way JP Morgan or any other big bank has the assets to pay out.
Is the financial system at risk? You bet, because the big mutual funds have all bought into each other, and all the big banks are playing the same game, so if one goes THEY ALL GO! That really will hurt everyone, whether you like it or not.
Now I am a scientist, not a financier, and I am no policy wonk.
But it seems to me that we need to get in place CDS regulations which do the following:
- As suggested by Devilstower, they must be regulated to assure proper assets for coverage like any other form of insurance. That is of course based upon risk assessment, but that will set premium rates and coverage appropriately.
- At present, unless I misunderstand insurance laws, you can only purchase insurance if you have a stake in what is being insured. To be macabre for the purposes of illustration, I cannot go out and purchase insurance on American soldiers in Afghanistan or Iraq. But that is precisely what you can do with CDS, in effect. That must stop.
- I think any CDS transaction needs a tax on it to slow down the process and keep the market from exploding further (although the demonstration that they are junk by this meltdown goes a long way to popping that bubble).
In terms of this bailout, I would like to insist the following if not in the bailout bill itself, in its wake:
- This may be what the FBI is doing now, but fraud inquiries should be instigated against the holders of CDS obligations, ie, the CEOs of the big banks. Because IF they kept selling these CDS contracts as though they could pay it all out and did not have the bucks to do so, how is that different than a pyramid scheme?
- This may be harder, because there is no CDS regulation on the books, but investigate whether similar charges can be brought against the buyers of CDS if they had no direct stake in the securities they were insuring. This should be a stronger case if it can be shown that they had insider knowledge of the potential collapse of the mortgage markets (although that took no rocket scientist to predict, Alan Greenspan's claims notwithstanding!).
- Consider marking down the payouts to naked buyers of CDS relative to those who legitimately bought insurance to protect their investments. Give them say a penny on the dollar of legit payouts. That way you uphold the contracts but you recognize the bogus speculation behind these payouts.
- Demand that the big banks and hedge funds surrender some of the equity they got as principle payments for the CDS contracts they held. This needs to be really explicit.
The CDS scheme then looks like a massive gaming of the financial system on a scale never before seen. It is not unlike the gaming of the energy markets by Enron. It is not unlike the S&L problem. But it is VAST in scope, and I am convinced that some action needs to be taken.
But I hope that our elected leaders put the blame where it lies (Mr. Bush, it is not foreign investors and easy credit to homebuyers that is the biggest problem here!) and explain to the American public what they will do to ensure this does not happen again!
Here are links to some other strong diaries on CDS which have appeared in recent days:
http://www.dailykos.com/...
http://www.dailykos.com/...
http://www.dailykos.com/...
http://www.dailykos.com/...
Updates
Link to a CDS primer (ht to BDA in VA
Linkto another DKos diary with similar thoughts and estimates of the ``naked'' buyer obligations.