WTF happened? Credit default swaps. $50 trillion notional value. $14 trillion U.S. 2008 GDP.
Just think of the financial system as a gigantic casino, kind of like the Sands before a wrecking ball knocked it down, where people bet against the house or on the house but the house burned down.
People bet even though they had no chips. Now the chips are down and they owe money to the bookies, aka "counterparties". But they have no money. But we do. Or rather, the Treasury and the Fed can keep printing money in the back room.
This entire betting area was unregulated, done in a dark alley. No one could see in and no one kept a record of his or her "contracts" or bets. A lot of the time they were made over the phone.
The reason these "agreements" were called credit default swaps: if they were called insurance, they would be regulated. No wagers without capital reserves to back them up in case of default. But people bet without any money in case of default. Or people bet without owning the underlying asset, as if someone could bet on your house burning down while you pay the premiums to the insurance company that couldn’t pay your claim.
No money put aside for a rainy day. Not enough rain to put out the fire.
When Lehman went bankrupt (or "was allowed to fail") all bets were off. Lehman owed money on bets against it and couldn’t pay off on bets it made. Shareholders were wiped out. Debt holders got pennies on the dollar. And credit froze. Investors were scared and still are. What if the government decides on a whim not to back up a failed bank/insurance company/commercial paper/money market fund? They’ll never get paid back. The banks don’t even trust each other.
No one can get money now unless it’s from the government and it’s a failed financial institution and it has well-paid lobbyists. Investment grade companies can’t borrow for less than 10% interest. Who can afford that kind of debt service? A lot of companies are being downgraded by the very credit rating agencies that slapped triple-A ratings on worthless paper.
What is the endgame?
The estimates as to how much money is committed to these CDS’s varies, but an oft-repeated figure is $50 trillion. $50 trillion. According to the Financial Forecast Center, the U.S. gross domestic product calculation ending in 12/08 (4th Q ’08) was $14.5 trillion. Simple arithmetic compels the question: how the hell are the American taxpayers supposed to cover these bets, if the goods and services we produce fall $35.5 trillion short?
Gretchen Morgenson, Pulitzer-prize winning reporter of the NYT, in her article "Time to Unravel the Knot of Credit Default Swaps" offers two ways to resolve this real problem at the bottom of the financial crisis.
Christopher Whalen, managing partner at Institutional Risk Analytics, suggests that:
Insurers (those collecting the premiums) have to put up 50% of their net exposure on a contact. By doing so, they eliminate doubts about financing of credit default swaps.
Regulators bar underwriters of credit protection from selling new insurance on financial institutions participating in TARP. “It is absurd for the government to allow private speculators to profit by trading about public-guaranteed liabilities of banks.
Sylvain R. Raynes, mathematics professor at Baruch College in New York and an expert in structured finance at R&R Consulting states that, “The financial system is frozen largely because of credit-default swaps. His suggestions include:
Unwinding all outstanding CDSs through a process he calls inversion. Insurance premiums would be refunded to buyers of credit protection from the entity that wrote the initial contract. And the seller would no longer be under an obligation to pay if a default occurred. The premium repayments would be made over the same period and at the same rate that they were paid out. If a contract was struck 3 years ago and charged quarterly premiums, the premiums would then be refunded quarterly over the next 3 years.
Remember the distinction between speculators and hedgers? They would be treated differently.
Hedgers—buyers who bought CDSs to protect themselves because they actually hold the underlying debt—would have their premiums refunded and get the difference between the underlying debt’s face value (say, $100) and an independent assessment of its intrinsic value.
How are these debts (especially mortgage-backed securities, which are illiquid) valued? Ascertained by third-party analyses using loan servicing data on delinquencies, defaults and performing mortgages.
Stop the clock. Reverse it. Then the entire system will be able to breathe again. Said Raynes, “And over time, at the same speed that you got into the mess, you get out of it.
Morgenson: “It won’t be easy: Wall Street and other beneficiaries of the current setup will scream. But since they are among those who helped bring our economy to its knees, let’s try ignoring their objections.”