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Monday, September 29, 2008

What are Credit Default Swaps?

I already wrote an article on How Collateralized Debt Obligations Work (CDOs). Credit default swaps are a highly leveraged financial instrument that leads to problems in a financial crisis. Due to lobbying by banks, credit default swaps are completely unregulated. Credit default swaps can be used in conjunction with mortgage CDOs or other types of debt. If you can name the asset class, you can swap for it.

Suppose you are a hedge fund manager, and you bought $1 billion of XYZ bonds. XYZ bonds may be corporate bonds, mortgage CDOs, or any type of financial instrument.

You can then enter into a "total return swap" agreement with a bank. Typically, the agreement will be "I pay the bank whatever the return on my XYZ bonds. The bank pays me the Fed Funds Rate minus a fee." The fee is based on how risky the XYZ asset is.

The bank will typically hedge this transaction. The bank will take a short position in XYZ bonds. Alternatively, if XYZ are corporate bonds, the bank may hedge by short selling the corporation's stock in the appropriate ratio. (If the corporation defaults on its bonds, its stock price will probably also decline sharply. Short selling a corporation's stock to hedge bonds is risky, because if the corporation does well there is a risk of unlimited loss.) Alternatively, the bank can say that it has a very diverse "credit default swap" portfolio. The bank doesn't need to hedge, because there won't be a bunch of defaults at the same time. This assumption is false, due to the Compound Interest Paradox.

When entering a "credit default swap", neither party posts collateral for the trade. The bank doesn't need to post collateral, due to the bank's presumed AAA credit rating. The hedge fund will put up its bonds as collateral.

A credit default swap allows someone to make a highly leveraged bet that a business will be forced into bankruptcy. "Credit default swaps" allow you to speculate on a company getting into financial trouble. Sometimes, you can enter a credit default swap trade even if you don't own the underlying bonds. This can lead to dishonest behavior. For example, I can buy a credit default swap on XYZ corporation's debt. Then, I can naked short sell XYZ corporation, creating the impression that XYZ is having financial trouble. In turn, this can cause customers to cease doing business with them, causing actual financial trouble.

The bank that issues the credit default swap is taking substantial risk. Either the bank hedges, or relies on the fact that it has made a large number of uncorrelated credit default swap trades. Due to fancy Mathematical models, the bank is taking on negligible risk.

Due to the Compound Interest Paradox, debt defaults are not uncorrelated. They are correlated. The fancy Mathematical models that justify credit default swaps are no good, because the assumptions are wrong.

When the bust occurs, banks must pay extra capital to their customers, as they demand payment for the swap. The customer trades his XYZ bonds for the return promised in the credit default swap. Most credit default swap agreements assume that the issuing bank has an AAA credit rating. Otherwise, the possibility of the bank defaulting should be subtracted from the fee charged. Only a "too big to fail" bank with an AAA credit rating can profitably sell credit default swaps. The credit default swap agreement usually contains a clause that says "If the issuing bank has a credit rating downgrade, then the customer may demand immediate payment or posting of collateral."

That is what happened to AIG. They wrote a whole bunch of credit default swap contracts as part of their insurance business. Selling a credit default swap is almost the same as selling insurance. However, AIG did not expect most of their credit default swaps to be in-the-money at the exact same time. Their fancy Mathematical models assumed that was a statistical impossibility. Then, all of AIG's customers demanded payment of their credit default swap agreements. This caused AIG to have a cashflow problem and led to a credit rating downgrade. After the downgrade, according to the terms of the credit default swap contracts, AIG had to post full collateral for the in-the-money credit default swaps AIG had sold. That's the reason AIG needed to raise $85 billion in a hurry, so it could meet these "margin calls" on its credit default swap contracts.

As another amusing anecdote, CDOs were introduced to "solve" the Savings and Loan crisis in the 1980s. Now, CDOs are "blamed" for the current financial meltdown. The problem is not CDOs. The problem is that fiat debt-based money is an inherently unsound system. Negative real interest rates encourage banks to load up on leverage so they can maximize their profits while exploiting the defect in the monetary system. Negative real interest rates cause banks to lobby for regulations that allow them to use more and more aggressive capital ratios. Then, during the economic bust, they are insolvent. The Compound Interest Paradox guarantees that there will be a boom/bust cycle every few years.

Due to the "too big to fail" problem, large banks *MUST* be bailed out, lest the entire economic system unravel. This creates the "moral hazard" problem or the "privatized profits, socialized losses" problem. During the boom years, CEOs and bank management load up on bonuses. During the bust years, they go to the Federal Reserve for a bailout in the form of an interest rate cut. This bust is so severe that banks must go to the Federal government for an explicit bailout.

The plan for the $700 billion bailout is that these lousy mortgage CDO bonds will be bought by the Federal government for more than the market value. The difference between the amount the Federal government pays and the market value of the debt is a pure subsidy/bailout for the financial industry.

The bailout isn't free. The average American will pay the cost as inflation. The bailout will increase the money supply and national debt by approximately 10%. With all the bad loans off their books, banks will be able to continue issuing new loans and inflating the money supply. In addition to the immediate 10% inflation hit, there also will be inflation over time as banks continue to issue new loans.

Instead of spending $700 billion bailing out banks, the Federal government could use that money to create new banks, and let the old ones fails. However, most large corporations have very complicated financial agreements with large banks. A large corporation is a great debtor. Due to its State-granted monopoly/oligopoly, a large corporation is practically guaranteed to be able to pay off its debts. If the "too big to fail" banks actually failed, then they would take a large number of their corporate customers into bankruptcy with them.

Currently, most large banks are technically insolvent. This means they can no longer issue new loans and inflate the money supply. If no bailout occurred, the money supply would crash in hyperdeflation due to the Compound Interest Paradox. Large banks would be unable to issue new loans and keep up the money supply.

From the point of view of the average American, the financial industry is a no-win game. Unless you invest in physical gold or silver, your savings will be eroded by inflation.

Average Americans are collectively paying $700 billion directly to bail out the financial industry. They also are paying the cost of financial industry profits over time, as their purchasing power is lost via inflation.

When I hear the bailout in the news, they talk about "Main Street" and "Wall Street". They say that Wall Street's problems will affect Main Street if there is no bailout. In this discussion "Main Street" refers to the productive aspect of the economy and "Wall Street" refers to the parasitic aspect of the economy. A better description of the bailout is "We must save the parasite, lest the host die." Feeding the parasite is more important than switching to a fair monetary system.

If you don't want your productivity and wealth leeched by the financial industry, agorism is the best practical solution. You should boycott the Federal Reserve and use gold or silver as money. You should avoid paying income taxes. Income taxes prevent people from boycotting the Federal Reserve. Interest payments on the national debt subsidize financial industry profits. Income taxes allow the State to leech 50% of your productivity directly, in addition to all the indirect costs of the Federal government.

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