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The Real Reason for the Global Financial Crisis…the Story No One's Talking About

[Part I of a three-part series looking at how so-called “credit default swap” derivatives could ignite a worldwide capital markets meltdown.]

By Shah Gilani
Contributing Editor

Are you shell-shocked? Are you wondering what's really going on in the market? The truth is probably more frightening than even your worst fears. And yet, you won't hear about it anywhere else because “they” can't tell you. “They” are the U.S. Federal Reserve and the U.S. Treasury Department, and they can't tell you what's really going on because there's nothing they can do about it, except what they've been trying to do – add liquidity.

At the exchange rate yesterday (Wednesday), 35 trillion British Pounds was equivalent to U.S. $62 trillion (hence, the 35 trillion Pound gorilla). According to the International Swaps and Derivatives Association, $62 trillion is the notional value of credit default swaps (CDS) out there, somewhere, in the market.

This isn't the first time Money Morning has warned readers about the dangers of credit default swaps. And it won't be the last.

The Genesis of a Derivative Boom

In the mid-1980s, upon arriving in New York from Chicago with an extensive background trading options and futures (the original derivatives), I was offered a job at what was then Citicorp [today's Citigroup Inc. (C)]. The offer was for an entry-level post in the bank's brand new OTC (over-the-counter, meaning not exchange traded) swaps and derivatives group. When I asked what the economic purpose of swaps was, the answer came back: “To make money for the bank.”

I declined the position.

It used to be that regulators and legislators demanded theoretical, empirical, and quantitative measures of the efficacy of new tradable instruments being proposed by exchanges. What is their purpose? How will they benefit the capital markets and the economy? And, what safeguards will accompany their introduction?

Not any more. In the early 1990s, in order to hedge their loan risks, J. P. Morgan & Co. [now JPMorgan Chase & Co. (JPM)] bankers devised credit default swaps.

A credit default swap is, essentially, an insurance contract between a protection buyer and a protection seller covering a corporation's, or sovereign's (the “referenced entity”), specific bond or loan. A protection buyer pays an upfront amount and yearly premiums to the protection seller to cover any loss on the face amount of the referenced bond or loan.
Typically, the insurance is for five years.

Credit default swaps are bilateral contracts, meaning they are private contracts between two parties. CDSs are subject only to the collateral and margin agreed to by contract. They are traded over-the-counter, usually by telephone. They are subject to re-sale to another party willing to enter into another contract. Most frighteningly, credit default swaps are subject to “counterparty risk.”

If the party providing the insurance protection – once it has collected its upfront payment and premiums – doesn't have the money to pay the insured buyer in the case of a default event affecting the referenced bond or loan (think hedge funds), or if the “insurer” goes bankrupt (Bear Stearns was almost there, and American International Group Inc. (AIG) was almost there) the buyer is not covered – period. The premium payments are gone, as is the insurance against default.

Credit default swaps are not standardized instruments. In fact, they technically aren't true securities in the classic sense of the word in that they're not transparent, aren't traded on any exchange, aren't subject to present securities laws, and aren't regulated. They are, however, at risk – all $62 trillion (the best guess by the ISDA) of them.

Fundamentally, this kind of derivative serves a real purpose – as a hedging device. The actual holders, or creditors, of outstanding corporate or sovereign loans and bonds might seek insurance to guarantee that the debts they are owed are repaid. That's the economic purpose of insurance.

What happened, however, is that risk speculators who wanted exposure to certain asset classes, various bonds and loans, or security pools such as residential and commercial mortgage-backed securities (yes, those same subprime mortgage-backed securities that you've been reading about), but didn't actually own the underlying credits, now had a means by which to speculate on them.

If you think XYZ Corp. is in trouble, and won't be able to pay back its bondholders, you can speculate by buying, and paying premiums for, credit default swaps on their bonds, which will pay you the full face amount of the bonds if they do actually default. If, on the other hand, you think that XYZ Corp. is doing just fine, and its bonds are as good as gold, you can offer insurance to a fellow speculator, who holds the opinion opposite yours. That means you'd essentially be speculating that the bonds would not default. You're hoping that you'll collect, and keep, all the premiums, and never have to pay off on the insurance. It's pure speculation.

Credit default swaps are not unlike me being able to insure your house, not with you, but with someone else entirely not connected to your house, so that if your house is washed away in the next hurricane I get paid its value. I'm speculating on an event. I'm making a bet.

The bad news is that there are even worse bets out there. There are credit default swaps written on subprime mortgage securities. It's bad enough that these subprime mortgage pools that banks, investment banks, insurance companies, hedge funds and others bought were over-rated and ended up falling precipitously in value as foreclosures mounted on the underlying mortgages in the pools.

What's even worse, however, is that speculators sold and bought trillions of dollars of insurance that these pools would, or wouldn't, default! The sellers of this insurance (AIG is one example) are getting killed as defaults continue to rise with no end in sight.

And this is only where the story begins.

The Ticking Time Bomb

What is happening in both the stock and credit markets is a direct result of what's playing out in the CDS market. The Fed could not let Bear Stearns enter bankruptcy because – and only because – the trillions of dollars of credit default swaps on its books would be wiped out. All the banks and institutions that had insurance written by Bear would not be able to say that they were insured or hedged anymore and they would have to write-down billions and billions of dollars in losses that they've been carrying at higher values because they could say that they were insured for those losses.

The counterparty risk that all Bear's trading partners were exposed to was so far and wide, and so deep, that if Bear was to enter bankruptcy it would take years to sort out the risk and losses. That was an untenable option.

The Fed had to bail out Bear Stearns.

The same thing has just happened to AIG. Make no mistake about it, there's nothing wrong with AIG's insurance subsidiaries – absolutely nothing. In fact, the Fed just made the best trade in its history by bailing AIG out and getting equity, warrants and charging the insurance giant seven points over the benchmark London Interbank Offered Rate (LIBOR) on that $85 billion loan!

What happened to AIG is simple: AIG got greedy. AIG, as of June 30, had written $441 billion worth of swaps on corporate bonds, and worse, mortgage-backed securities. As the value of these insured-referenced entities fell, AIG had massive write-downs and additionally had to post more collateral. And when its ratings were downgraded on Monday evening, the company had to post even more collateral, which it didn't have.

In short, what happened in one small AIG corporate subsidiary blew apart the largest insurance company in the world.

But there's more – a lot more. These instruments are causing many of the massive write-downs at banks, investment banks and insurance companies. Knowing what all this means for hedge funds, the credit markets and the stock market is the key to understanding where this might end and how.

The rest of the story will be illuminated in the next two installments. Next up: An examination of the AIG collapse, followed by a look at how bad things could get, and what we can do to fix the problem at hand. So stay tuned.

[Editor's Note: Contributing Editor R. Shah Gilani has toiled in the trading pits in Chicago, run trading desks in New York, operated as a broker/dealer and managed everything from hedge funds to currency accounts. In his new column, "Inside Wall Street," Gilani promises to take readers on a journey through the "shadowy back alleys" of the U.S. capital markets – and to conduct us past the "velvet rope" that guards Wall Street's most-valuable secrets – in an ongoing search for the investment ideas with the biggest profit potential. If the whipsaw markets we're experiencing lead to the so-called market “Super Crash” that many analysts fear, shrewd investors won't have to worry. The reason: They will be able to capitalize on the once-in-a-lifetime profit plays that we detail in a new report. For a copy of that report – which includes a free copy of CNBC analyst Peter D. Schiff's New York Times best-seller, "Crash Proof: How to Profit from the Coming Economic Collapse" – please click here.]

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About the Author

Shah Gilani is the Event Trading Specialist for Money Map Press. He provides specific trading recommendations in Capital Wave Forecast, where he predicts gigantic "waves" of money forming and shows you how to play them for the biggest gains. In Zenith Trading Circle Shah reveals the worst companies in the markets - right from his coveted Bankruptcy Almanac - and how readers can trade them over and over again for huge gains. He also writes our most talked-about publication, Wall Street Insights & Indictments, where he reveals how Wall Street's high-stakes game is really played.

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  1. Frances Bieda | September 24, 2008

    Finally, someone has thoroughly explained the real reason for the mess happening with all the banks and investment banks. On regular TV, radio and I hate to say even on most XM radio stations, all I hear is the over simplified reason of "drop in home prices" are the root of this problem. Really? Mr. Shah Gilani, THANK YOU. You explained this very well. A lot of what is happening now reminds me of what happened with LTCM in 1998. This company flourished for four years on derivatives and bond spreads, borrowing enormous amounts of money from numerous investment banks and wealthy investors until the Feds came in and bailed them out in 1998. Interesting how many of those investment banks who invested with LTCM back then, are the very same ones the Fed is bailing out today! Alan Greenspan admitted if the Fed bailed them out, it would encourage more of this same type of risk taking investing in the future. The root of this mortgage meltdown is not only easy credit but investment banks behaving like a gambler in a casino. Bet you can guess who gets to bail them out again.

  2. Dave | September 26, 2008

    How come no one is talking about the other main factor in all this? We're talking about credit defaults, right? People who can't pay their bills, and, why is that? Isn't globalization and the loss of millions of jobs to outsourcing and insourcing a major factor in all this.

    Seriously, a few years of subprime loans is bringing down the entire world's economy? Are people really walking away from their home loans because their houses are worth 10%-20% less? Are people really walking away from their home loans because interest rates are making them unaffordable? Non of that makes sense! People aren’t just going to walk away because their house loses value. And the idea that ARMs are killing every one is ridiculous as there is an easy fix to that. What does make sense is people walking away from their bills because they no longer have jobs!

    I'm a computer software developer and have been for more than 20 years. Never had trouble finding work until 2000+. Now it's hard to get a company to give you the time of day. And yet you see their tech departments full of foreign workers.

    Subprime credit issues — give me a break! How about American companies moving out and taking millions of jobs with them! And if they aren’t moving out their laying people off and replacing them with Mexicans, Indians and Chinese. Just how stupid are we?

  3. Danny | October 1, 2008

    Shah Gilani is one of the best financial writers in the world. I have turned on all my coworkers to this website and we discuss these articles. It's a great education for a the common man.


  4. Jon C. Fox | October 8, 2008

    Are Chinese banks, financiers or other Chinese financial institutions allowed to buy or sell CDSs? If not, then as credit chokes for all other institutions and commercial paper is stopped because of the coming due of the CDSs, the Chinese banks (HSBC; Bank of China? etc) will not be affected. It might even provide the short-term loans needed by large corporations that are not available in the USA or Europe. This might eventually lead to control of all financial markets by the Chinese.

    Or – are the large Chinese corporations, and Chinese banks and financial institutions just as choked by the coming due of the Credit Default Swaps as USA and European banks and financial institutions (and hence corporations than can't get commecial paper)?

  5. Margaret | October 12, 2008

    This is good article finally I understand some of the issue that Government do not want to explain to taxpayers.

  6. Williams | October 13, 2008

    Is this a joke? Larouche has been talking about exactly this problem for years!

  7. PDSimic | November 11, 2008

    The fundamental point seems that the CDS, being an unregulated OTC instrument, could have been entered as a way to bet on a default of some reference debt obligation to which the "protection" buyer had no economic exposure. While this is outrageous, there is a good news too. The good news is that speculators, not having a real exposure to the reference debt obligation can not possibly claim any real loss in the case of default of either insurance company or the reference debt obligation. All they could claim is a loss of opportunity to profit enormously from a successful bet that should never been allowed in the first place.

    So, the leverage of this type and the "loss" due to contractual obligations of insurers towards CDS speculators should not be considered a real problem, because there is no real "loss" involved. To handle this the government should simply use its powers to cancel in an orderly way all the CDS contracts where the buyer of the credit insurance does not have an actual exposure to the reference debt obligation; dollar for dollar.

    The only liability left and acknowledged, to be subject of the government-assisted arbitrage, is a potential compensation for the premium already payed by the buyers. This, however, is something that could be resolved in a fair and orderly way, and would amount to unwind of the will-give-you-back-the-premiums-you-payed type. The total amount of money involved in reimbursing the insurance premiums payed so far by the buyers of the speculative CDS's will be much, much smaller then the gigantic leverage involved in these CDS's today.

    Such an action by our government would drastically reduce the "CDS threat" that this article is talking about, as it would essentially eliminate a massive dollar-value-at-risk in the existing speculative CDS positions. The CDS positions left to live would be the ones where buyer of the insurance have for each dollar of insurance a dollar of actual exposure to the reference obligation. Such CDS positions would represent much smaller total dollar at risk value and while problem for insurance sellers in bad economy, would not be fatal for well capitalized insurers, or for the economy.

    So, I would claim that solution to the CDS leverage problem is, in principle, simple, and boils down to the willingness of the government to cancel or unwind all the speculative CDS contracts that are not based on CDS buyers real economic exposure to the reference debt obligation. This should not be hard because the speculator CDS buyer has no real exposure to the reference obligation default, and therefore no real loss.The only loss for speculator CDS buyer is a loss of opportunity to make a huge profit.Such loss, obviously, should not be concern of the Main St. and should never be compensatede for by the taxpayers money.

  8. chand akhtar ansari | November 12, 2008

    it was queit good to understand the present financial crisis.

  9. Gerald Spencer | December 19, 2008

    If only we had kept the cash-in/cash-out accounting standards and the gold redemption for our currency.

  10. fasieh | February 3, 2009

    Global Financial CRISIS?
    how has securitisation markets and securitised products played a significant role in the global financial crisis?

    one of the widely discussed innovative finance model based on securitisation appears to hae failed. will the financial markets get back to business of securitisation in its present form or with a new face?

    whats the future prospect of securitisation? how do you perceive it?

  11. lisek | May 18, 2009

    For my opinion, the real reason for the global financial crisis is gravity of Jupiter. In years 1997-2000 I have written a program, that calculated current crisis (2008-2010) on (gravity) idea of Chinese calendar,

  12. Evelyn | December 21, 2009

    Why is it that we are in this financial crisis? Because people are spending money we dont have, and not only that but the things that are really messing the people up is using credit cards and such, people are just making things worse for themselves. Why is it?

  13. ragz | October 24, 2011

    Very nice article written in easiest terms possible….thank you !!


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