Crash of 2008: Credit Default Swaps, Part II

This article sums up one of the underlying reasons for the financial troubles that the world is currently experiencing. As I noted in this post, derivatives - namely Credit Default Swaps (CDS) - have played a pivotal role in the global economy's dizzying expansion...and subsequent downfall. This article explains the scheme in more detail.

Around the world, banks must comply with what are known as Basel II regulations. These regulations determine how much capital a bank must maintain in reserve. The rules are based on the quality of the bank's loan book. The riskier the loans a bank owns, the more capital it must keep in reserve. Bank managers naturally seek to employ as much leverage as they can, especially when interest rates are low, to maximize profits. AIG appeared to offer banks a way to get around the Basel rules, via unregulated insurance contracts, known as credit default swaps.

Here's how it worked: Say you're a major European bank... You have a surplus of deposits, because in Europe people actually still bother to save money. You're looking for something to maximize the spread between what you must pay for deposits and what you're able to earn lending. You want it to be safe and reliable, but also pay the highest possible annual interest. You know you could buy a portfolio of high-yielding subprime mortgages. But doing so will limit the amount of leverage you can employ, which will limit returns.

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Although AIG's credit default swaps were really insurance contracts, they weren't regulated. That meant AIG didn't have to put up any capital as collateral on its swaps, as long as it maintained a triple-A credit rating. There was no real capital cost to selling these swaps; there was no limit. And thanks to what's called "mark-to-market" accounting, AIG could book the profit from a five-year credit default swap as soon as the contract was sold, based on the expected default rate.

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It was a fraud. AIG never any capital to back up the insurance it sold. And the profits it booked never materialized. The default rate on mortgage securities underwritten in 2005, 2006, and 2007 turned out to be multiples higher than expected. And they continue to increase. In some cases, the securities the banks claimed were triple A have ended up being worth less than $0.15 on the dollar.

Even so, it all worked for years. Banks leveraged deposits to the hilt. Wall Street packaged and sold dumb mortgages as securities. And AIG sold credit default swaps without bothering to collateralize the risk. An enormous amount of capital was created out of thin air and tossed into global real estate markets.

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AIG's largest trading partner wasn't a nameless European bank. It was Goldman Sachs.

I'd wondered for years how Goldman avoided the kind of huge mortgage-related writedowns that plagued all the other investment banks. And now we know: Goldman hedged its exposure via credit default swaps with AIG. Sources inside Goldman say the company's exposure to AIG exceeded $20 billion, meaning the moment AIG was downgraded, Goldman had to begin marking down the value of its assets. And the moment AIG went bankrupt, Goldman lost $20 billion. Goldman immediately sought out Warren Buffett to raise $5 billion of additional capital, which also helped it raise another $5 billion via a public offering.

The collapse of the credit default swap market also meant the investment banks – all of them – had no way to borrow money, because no one would insure their obligations.

Now the only place for these institutions to get capital is the Federal Reserve. Unfortunately, very few folks believe that the recent $700B 'bailout' package will have the intended result. Markets around the globe fell decisively this Monday. One reason: perhaps there just isn't a way to replace the credit...

There's no way to replace this massive credit-building machine, which makes me very skeptical of the government's bailout plan. Quite simply, we can't replace the credit that existed in the world before September 15 because it didn't deserve to be there in the first place. While the government can, and certainly will, paper over the gaping holes left by this enormous credit collapse, it can't actually replace the trust and credit that existed... because it was a fraud.

And that leads me to believe the coming economic contraction will be longer and deeper than most people understand.

The author then gives some investment advice, which I am unsure of the impartiality or validity. I don't feel that this should detract from the explanation of the situation, however. There seem to be many people hawking gold these days - who knows if any drastic maneuvers are a good idea. Bottom line, we may be in for some rough times in the years ahead, and it may be a good time to seek professional investment advice.