WARNING! ATTENTION SPAN REQUIRED!


CREDIT DEFAULT SWAPS:
DERIVATIVE DISASTER DU JOUR

Ellen Brown, April 10th, 2008
http://www.webofdebt.com/articles/derivative-disaster.php

When the smartest guys in the room designed their credit default swaps, they forgot to ask one thing – what if the parties on the other side of the bet don't have the money to pay up? Credit default swaps (CDS) are insurance-like contracts that are sold as protection against default on loans, but CDS are not ordinary insurance.
Insurance companies are regulated by the government, with reserve requirements, statutory limits, and examiners routinely showing up to check the books to make sure the money is there to cover potential claims.
CDS are private bets, and the Federal Reserve from the time of Alan Greenspan has insisted that regulators keep hands off. The sacrosanct free market would supposedly regulate itself.
The problem with that approach is that regulations are just rules. If there are no rules, the players can cheat; and cheat they have, with a gambler's addiction.
In December 2007, the Bank for International Settlements reported derivative trades tallying in at $681 trillion – ten times the gross domestic product of all the countries in the world combined.
Somebody is obviously bluffing about the money being brought to the game, and that realization has made for some very jittery markets.
"Derivatives" are complex bank creations that are very hard to understand, but the basic idea is that you can insure an investment you want to go up by betting it will go down.
The simplest form of derivative is a short sale: you can place a bet that some asset you own will go down, so that you are covered whichever way the asset moves. Credit default swaps are the most widely traded form of credit derivative. They are bets between two parties on whether or not a company will default on its bonds.
In a typical default swap, the "protection buyer" gets a large payoff if the company defaults within a certain period of time, while the "protection seller" collects periodic payments for assuming the risk of default.
CDS thus resemble insurance policies, but there is no requirement to actually hold any asset or suffer any loss, so CDS are widely used just to speculate on market changes. In one blogger's example, a hedge fund wanting to increase its profits could sit back and collect $320,000 a year in premiums just for selling "protection" on a risky BBB junk bond.
The premiums are "free" money – free until the bond actually goes into default, when the hedge fund could be on the hook for $100 million in claims. And there's the catch: what if the hedge fund doesn't have the $100 million? The fund's corporate shell or limited partnership is put into bankruptcy, but that hardly helps the "protection buyers" who thought they were covered.
To the extent that CDS are being sold as "insurance," they are looking more like insurance fraud; and that fact has particularly hit home with the ratings downgrades of the "monoline" insurers and the recent collapse of Bear Stearns, a leading Wall Street investment brokerage.
The monolines are so-called because they are allowed to insure only one industry, the bond industry. Monoline bond insurers are the biggest protection writers for CDS, and Bear Stearns was the twelfth largest counterparty to credit default swap trades in 2006.1 These players have been major protection sellers in a massive web of credit default swaps, and when the "protection" goes, the whole fragile derivative pyramid will go with it.
The collapse of the derivative monster thus appears to be both imminent and inevitable, but that fact need not be cause for despair.
The $681 trillion derivatives trade is the last supersized bubble in a 300-year Ponzi scheme, one that has now taken over the entire monetary system. The nation's wealth has been drained into private vaults, leaving scarcity in its wake. It is a corrupt system, and change is long overdue. Major crises are major opportunities for change.

The Wall Street Ponzi Scheme

The Ponzi scheme that has gone bad is not just another misguided investment strategy. It is at the very heart of the banking business, the thing that has propped it up over the course of three centuries.
A Ponzi scheme is a form of pyramid scheme in which new investors must continually be sucked in at the bottom to support the investors at the top. In this case, new borrowers must continually be sucked in to support the creditors at the top.
The Wall Street Ponzi scheme is built on "fractional reserve" lending, which allows banks to create "credit" (or "debt") with accounting entries. Banks are now allowed to lend from 10 to 30 times their "reserves," essentially counterfeiting the money they lend.
Over 97 percent of the U.S. money supply (M3) has been created by banks in this way.2 The problem is that banks create only the principal and not the interest necessary to pay back their loans, so new borrowers must continually be found to take out new loans just to create enough "money" (or "credit") to service the old loans composing the money supply.
The scramble to find new debtors has now gone on for over 300 years – ever since the founding of the Bank of England in 1694 – until the whole world has become mired in debt to the bankers' private money monopoly.
The Ponzi scheme has finally reached its mathematical limits: we are "all borrowed up."
When the banks ran out of creditworthy borrowers, they had to turn to uncreditworthy "subprime" borrowers; and to avoid losses from default, they moved these risky mortgages off their books by bundling them into "securities" and selling them to investors.

To induce investors to buy, these securities were then "insured" with credit default swaps. But the housing bubble itself was another Ponzi scheme, and eventually there were no more borrowers to be sucked in at the bottom who could afford the ever-inflating home prices. When the subprime borrowers quit paying, the investors quit buying mortgage-backed securities.
The banks were then left holding their own suspect paper; and without triple-A ratings, there is little chance that buyers for this "junk" will be found.
The crisis is not, however, in the economy itself, which is fundamentally sound – or would be with a proper credit system to oil the wheels of production.
The crisis is in the banking system, which can no longer cover up the shell game it has played for three centuries with other people's money.

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