Monday, October 06, 2008

To Grasp Reality

For over a year now, I have been warning of a complete systemic collapse of the U.S. Banking System. I was a bit biased towards the downside to begin with, as I started working in finance as a trader during the month of August in 2007. This was when the world found out that the seemingly impenetrable, multinational banking institutions, the symbols of American might that turned regular college students into Pavlov's drooling dog, were susceptible to reality. 120k earnings your first year out of school? Maserati at 28? It was, it turned out, just a dream.

I posted graphs from the Federal Reserve which I thought would illustrate why I believed this could turn into a depression. I made many timley macroeconomic predictions, and some individual stock predictions, and I routinely warned about an esoteric but sixty-two trillion dollar market called CDS.

The only one of my predictions from late 2007 to early 2008 that has not panned out(I never claimed with certainty we would go into a depression) is the complete collapse of the CDS market - the market Warren Buffet labeled as a "financial time bomb" whose architects were "mad men." I never really used the term depression to describe the events that would follow a CDS market implosion, but internally and in my discussions with others, I think it was clear that if this market were to fail, then "that would be it." Bernake and Paulson also seem to think so(AIG, Bear Stearns).

But these predictions were all made on paper - through research and diligence, technical analysis and fundamental calculations. I never really knew what it would feel like to actually live through this nightmare - through "hard times" - indeed, I think many kids our age forgot that the economy can have a seizure. The last twenty years have been an age of incredible wealth creation.

Main St. has not had hard times yet. But I think anyone with a grasp of reality can see where this is headed. Things will be very hard - and if the CDS market implodes - as I have said in early January and many other times - get ready for an outright catastrophe - massive instability will ensue. This is by god the only market we should care about right now - not the subprime bonds, not the bad loans that Hank Paulson wants to buy up and remove from the balance sheets of institutions, but the Credit Default Swaps market - whose purpose was to protect against the defaulting of corporate debt held by one party in the form of a one time payment if that debt ever defaulted. The payments are huge - like in the billions. No one has this money now. And no one had it to begin with - CDS is a legal contract but the capital commitments outlined in the contracts were not checked by any party. Now the total outstanding value of the CDS market is 62 trillion dollars - 4 times the size of the American economy. Parties have legally binding commitments to payup when a credit event occurs, but no one has the money now to pay, and some people never had the money to begin with!

So for example, if Bank Fish promises to protect Bank Huffy for James' TShirt Store, and the store goes plooie, then Bank Fish has to pay Bank Huffy a certain amount of money. Many of these payments are in the billions of the dollars - in fact I would say a billion dollars is the average. The bankruptcy rate prior to October 2007 was about .26 percent....way out of historical norms of a 1.25 percent default rate. Since we are in a financial tsunami, that rate is going to be much higher than this 1.25 percent normal average. Now, the geniuses of these CDS contracts didn't realize that their selfish interests would also create widespread risk - if James' T Shirt Shop goes bankrupt, and Bank Fish has to pay 1 billion, and Bank Fish is impaired, then Bank Fish is gonna go bankrupt, and now Bank Huffy, who promised to pay Bank Lick if Bank Fish went bankrupt, has to have 1 billion in capital outflows during a severe recession, and is gonna go plooie.

What got me thinking about this again was Yves latest post on nakedcap saying that the first settlement(when money changes hands) for the Fannie, Freddie, Wamu, and Lehman bankruptcies is this month. Granted, I don't think there are going to be major problems with this month's CDS contracts because many people hedged their risks - people have known that these institutions were in trouble for quite some time . However, according to today's FT, the contract value on Fannie and Freddie is 400B, with 35B of that 400B expected to be paid out by sellers. Who has this kind of money to spare nowadays? Do you see the problem?

The reality to grasp here is that it will be difficult to stop the CDS market from imploding. In fact, as long as the federal government bails out institutions and prevents any of the markets from clearing, the longer they continue to intervene(to a point), the worse shape companies will be in for the CDS tsunami...and the less likely they will be able to pay what their contracts say they must.

The Fed is again having an emergency meeting on Tuesday with the banks to set up a clearing house of some sort which will allow the CDS market to be organized better. In the future such an agency will verify capital commitments made by the paries, and right now, it will be primarily used for 'net-settlement', which is a way of hedging your risk on a specific CDS contract..basically nuetraling it out.

The Fed is preparing for the CDS storm and so should you. The CDS situation is more than just an economic issue for the parties involved, it goes right into the heart of trust in the system(62 trillion? are you kidding), the financial system, the legal system, and of course the regulators - who allowed such a monstrosity to occur. They only mandated paperwork be kept for such things in 2004. Before that, you need not even have a record.

As more entities go bankrupt, more contracts with be triggered. Then, more people will not be able to pay their obligations and will go bankrupt. Rinse and repeat. Or you might just want to take a shower after the bloodbath.

1 Comments:

Blogger curry king said...

John McCain was warning about corruption in Fannie and Freddie a year ago as well.

10:57 PM  

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