I’ve talked about the “monoline nuke” before on a number of occasions, mainly in the context of what could set it off. This week, I’m going to talk about what that nuke could do. Just like the shockwave of a nuclear explosion would mow down anything in its path, the monoline nuke could take out towering structures of trillions in derivatives, more specifically credit default swaps.
Do yourself a favor and read the CNBC-NY Times article, it’s very informative as to what we’re truly facing in this crisis, but I’ll cover the highlights…from subprimes to monolines to credit default swaps, it’s all coming unglued.
Few Americans have heard of credit default swaps, arcane financial instruments invented by Wall Street about a decade ago. But if the economy keeps slowing, credit default swaps, like subprime mortgages, may become a household term.
Credit default swaps form a large but obscure market that will be put to its first big test as a looming economic downturn strains companies’ finances. Like a homeowner’s policy that insures against a flood or fire, these instruments are intended to cover losses to banks and bondholders when companies fail to pay their debts.
The market for these securities is enormous. Since 2000, it has ballooned from $900 billion to more than $45.5 trillion — roughly twice the size of the entire United States stock market.
No one knows how troubled the credit swaps market is, because, like the now-distressed market for subprime mortgage securities, it is unregulated. But because swaps have proliferated so rapidly, experts say that a hiccup in this market could set off a chain reaction of losses at financial institutions, making it even harder for borrowers to get loans that grease economic activity.
Keep in mind that this untested, largely unregulated market is worth more than the stock market and the US yearly GDP combined. It’s never been through a major crisis like this. What happens when $45 trillion dollars worth of market freezes up because nobody’s sure what each piece of it is truly worth?
In a credit default swap, two parties enter a private contract in which the buyer of protection agrees to pay the seller premiums over a set period of time; the seller pays only if a particular credit crisis occurs, like a default. These instruments can be sold, on either end of the contract, by the insurer or the insured.
But during the credit market upheaval in August, 14 percent of trades in these contracts were unconfirmed, meaning one of the parties in the resale transaction was unidentified in trade documents and remained unknown 30 days later. In December, that number stood at 13 percent. Because these trades are unregulated, there is no requirement that all parties to a contract be told when it is sold.
As investors who have purchased such swaps try to cash them in, they may have trouble tracking down who is supposed to pay their claims.
Let’s think about that and do the math. There’s $45 trillion dollars in CDS paper out there. A full 13 percent of that market has an unknown owner. That’s roughly SIX TRILLION DOLLARS that’s unaccounted for. Half our GDP. Two-thirds of our entire national debt. We don’t know who owns it, who sold it, who really has it. You can write off billions. Can you write off trillions?
When people are uncertain about a complex derivative product, they want to get real money for it. If everyone cashes in at the same time…cashes in trillions of dollars in CDS paper…it’s over. Nobody will be able to afford to pay off these IOUs.
The Housing Bubble caused the Subprime Crisis. The Subprime Crisis is about to trigger the Monoline Nuke. The Monoline Nuke would in turn trigger Derivative Armageddon.
This shadow market is worth more than the actual wealth the US actually has. More than the GDP, stock market, and National Debt combined. If it goes down, what do you think will happen to the company you work for? The companies that supply to company you work for? The companies that pay people so they can buy the products of the company you work for?
Are you getting the picture now of just how bad this is going to be?
“This is just a giant insurance industry that is underregulated and not very well reserved for and does not have very good standards as a result,” said Michael A. J. Farrell, chief executive of Annaly Capital Management in New York. “I think unregulated markets that overshadow, in terms of size, the regulated ones are a real question mark.”
Because these contracts are sold and resold among financial institutions, an original buyer may not know that a new, potentially weaker entity has taken over the obligation to pay a claim.
When people start to realize there’s no buyers for CDS paper anymore, then this massive $45 trillion dollar market freezes up and along with it the economy.
That’s why the monoline insurers are so vital. They insure these defaults. The credit default swaps market is in effect a $45 trillion market of IOUs. As long as nobody actually defaults on these things, nobody actually has to pay up. As long as the economy stays good, there’s no problem. Just like the mortgage market, as long as values of homes went up, there was no problem. People assumed the housing market would continue to go up forever. Just like the mortgage securitization market, the assumption was that the companies and government entities behind the CDS market would be simply too big to ever default. Buying insurance on something that you would never need to insure seems insane (and it was) but it was also a sure thing. It was purchasing certainty, and it was then leveraged at a 1000% plus. It was a golden planet on which all the lifeforms were golden geese that laid golden eggs.
History is littered with the corpses of “sure things”.
Now that the subprime crisis has caused the US economy to spring a leak, the whole thing is coming undone. The monolines on the hook should these defaults need to be cashed in. The more defaults there are, the more people will want to cash in on them and get out of the market.
So what happens when a $45 trillion market, untested in a downward cycle let alone a recessionary contraction, unregulated, and mostly not understood by the people who created it, gets close to toppling over?
Game over.
We do know some of the players in this market.
JPMorgan Chase , with $7.8 trillion, is the largest player; Citibank and Bank of America are behind it with $3 trillion and $1.6 trillion respectively.
But many speculators, particularly hedge funds, have flocked to these instruments to bet on a company failure easily. Before the insurance was developed, such a bet would require selling short a corporation’s bond and going into the market to borrow it to supply to the buyer.
The market’s popularity raises the possibility that undercapitalized participants could have trouble paying their obligations.
Does anyone here think JP Morgan Chase is good for $7.6 trillion dollars should the CDS market go bad? What happens if JPMC gets called out to make good on even one percent of that total, or $76 billion dollars?
What would happen to the stock markets? The financial industry? The economy? Consumer confidence? That’s one player in the CDS market at one percent of their CDS leveraged holdings.
Poof. Gone, overnight. The Big One. It would make the $300 billion in subprime losses look like chump change.
Here’s the heart of the matter.
Roughly one-third of the credit default swaps provided insurance against a default by a specific corporate debt issuer in 2006, according to the British Bankers’ Association. Around 30 percent of the contracts were written against indexes representing baskets of debt from numerous issuers.
But 16 percent were created to protect holders of collateralized debt obligations, complex pools of bonds that have recently experienced problems because of mortgage holdings.
There is no exchange where these insurance contracts trade, and their prices are not reported to the public. Because of this, institutions typically value them based on computer models rather than prices set by the market.
Neither are the participants overseen by regulators verifying that the parties to the transactions can meet their obligations.
So roughly $7 trillion of CDS paper has been taken out on mortgage defaults. Let’s think about this.
The potential for problems in sizing up the financial health of buyers of these securities leads to questions about how these insurance contracts are being valued on banks’ books.
A bank that has bought protection to cover its corporate bond exposure thinks it is hedged and therefore does not write off paper losses it may incur on those bond holdings. If the party who sold the insurance cannot pay on its claim in the event of a default, however, the bank’s losses would have to be reflected on its books.
What would $7 trillion in default claims do to the financial sector? What would it do when banks who believed they were solvent suddenly had to write off not just billions, but tens or hundreds of billions? What would it do to the economy? Banks would not just fail, they would collapse and take solvent banks with them with bank runs on the fractional reserve cash. It would be the Great Depression all over again, and it would potentially unravel the entire global banking system. The world would plunge into the abyss.
The world’s financial experts are not prepared to handle a crisis of this magnitude. People would start turning to things of tangible value: gold, oil, and increasingly, water. If you think the resource wars of the 21st century are bad now, wait until this explosion goes off.
Investors are already reeling from the recognition that major banks inaccurately estimated losses from the mortgage debacle. If further write-downs emerge as a result of hedges that did not work, investor confidence could take another dive.
Take another dive. That’s cute. By dive if you mean “massive bank runs that will collapse the economy overnight” then sure, it’ll be another dive. When the reports hit the net and the financial press that America’s megabanks are failing, that they are writing off hundreds of billions, people will take their money out of their own bank. They will say “If JP Morgan Chase and Citibank are going under, my bank might be in trouble too.” It won’t take much as low as bank cash reserves are right now. Maybe 1% of America taking out their deposits on the same day.
Then the reports will start coming in on banks being out of cash. Then people will get really scared. “Holy crap Martha, we need to get our money out of the bank!”
Surely we’ll get to see some quality federal government crisis management like during Katrina. Those detention centers will probably get a work out in that kind of situation.
Riots. Martial law. Mass detentions of citizens. General unpleasantness. Everything in this country is leveraged, from our financial system to our food supply to our labor supply to the paychecks we get. It’s all just-in-time delivery of parts, foodstuffs, and people. If the system breaks down, it won’t be able to be simply rebooted.
Could you afford to miss a paycheck due to your bank having issues with direct deposit because of bank runs? What about the people who cash their paychecks? What if even 2% of Americans see the bank run stories on the news and say “You know what? This Friday I’m taking out my paycheck in cash.”
What happens is a disaster repeated in every major city in the United States of America.
It’s the financial sector that makes the ultra-leveraged, just-in-time system work. If it goes down, it all goes down.
To be sure, the $45 trillion in credit default swaps is not an exact reflection of what would be lost or won if all the underlying securities defaulted. That figure is impossible to pinpoint since the amounts that are recovered in default situations vary.
But one of the challenges facing participants in the credit default swap market is that the market value amount of the contracts outstanding far exceeds the $5.7 trillion of the corporate bonds whose defaults the swaps were created to protect against.
Again, everything is ultra-leveraged. $5.7 trillion in bonds are leveraged against almost nine times that Credit Default Swaps. If the small things break down, that leverage in turn destroys much, much larger systems.
And we’ve already seen it happen. There are defaults in the bond market, but so far the system has held up.
To the uninitiated trying to understand this complex market, its size might initially seem a comfort, as if there were far more insurance covering the bonds than could ever be needed.
But because each contract must be settled between buyer and seller if a default occurs, this imbalance can present a problem.
Typically, settling the agreements has required the delivery of defaulted bonds if the insurance buyer wants to be fully covered. If the insurance contracts exceed the bonds that are available for delivery, problems arise.
For example, when Delphi, the auto parts maker, filed for bankruptcy in October 2005, the credit default swaps on the company’s debt exceeded the value of underlying bonds tenfold.
Buyers of credit insurance scrambled to buy the bonds, driving up their price to around 70 cents on the dollar, a startlingly high value for defaulted debt.
Market participants worked out an auction system where settlements of Delphi contracts could be made even if the bonds could not be physically delivered.
This arrangement was done at just over 36 cents on the dollar; so buyers of protection on Delphi who did not have the bonds received $366.25 for every $1,000 in coverage they had bought. Had they been valuing their Delphi insurance coverage at $1,000 per bond, they would have had to write off that position by $633.75 per $1,000 bond.
Again, what happens when the system is so overwhelmed by defaults that it can’t handle it? Nobody knows who has what, only that everybody else owes them a lot of money.
A lot of money that will never be repaid. The Delphi auto parts example is instructive because the default on that bond would have been catastrophic without the insurance.
Now keep in mind this market is largely unregulated and worth more than our entire yearly economy combined. And it’s starting to come apart.
Are you beginning to see the disaster awaiting? The dominoes are already falling. Stopping them will take a super-human effort…and we have the Bush Administration in charge right now.
Even if there was an equitable and fair solution to the problem, at every turn this administration has shown that it’s more than willing to fuck over the little people in order to reward the top 1% of Americans every single time. We need King Solomon, Jefferson, Hammurabi, Sophocles, or Charlemagne. Instead, we have Dubya, Condi, Cheney and Helicopter Ben.
What makes you think this is going to be any different? This is a government that left hundreds of thousands in the lurch, and almost three years later NOLA is still a third-world fiefdom in a first-world country. The rest of us are about to join them should the worst-case scenario come to pass.
“The insurance business is very difficult to quantify risk in,” said Mr. Farrell of Annaly Capital Management. “You have to really read the contract to make sure you are covered. That is going to be the test of the market this year. As defaults kick in and as these events unfold, you are going to find out who has managed this well.”
And who hasn’t.
And of course that goes for the government too. Do you think they have managed this crisis well so far? What they are doing is buying time for the people up top to get out, and the rest of us are going to be holding the bag.
And actually, that bag is going to get tied around our necks, filled with concrete, and then tossed in the lake.
The Monoline Nuke will detonate this market. There may already be enough damage from subprime to crumble this market alone, regardless of what the monolines actually do. Banks are still walking around holding IOUs with big question marks on them. Eventually somebody’s going to want to pay up on them.
When that bill comes due, we’re all going to pay. Dearly.