Money For Nothing.

I was trying to explain to my wife how credit default swaps work, and why we are not only in danger of another financial meltdown, but are probably closer than we were in 2007. I know, I’m a barrel of laughs. But, the next big bank failure, if it happens, will cost far more than the $800B we pissed away in the TARP bailout. This time we will be talking REAL money.

In the decade since credit-default swaps were invented, the market has exploded in size, to some $62 trillion of CDS deals outstanding from just $1 trillion in 2000, according to industry estimates. This dwarfs the size of the underlying bond issues.

Beyond concerns about its size, the CDS market seems to have become a weapon of mass speculation that is destabilizing international debt and even equity markets. That looks to be true in the subprime-debt-induced crisis of 2008 that still has the credit markets in a deep-freeze. At the height of the crisis, in the first quarter of 2007, the price of credit-default insurance for key financial companies zoomed to once-unimaginable heights, signaling rightly or wrongly the imminent default of their debt issues.

The run-up was induced partly by panic among debt holders and others seeking to hedge their financial exposure at any price. But other factors, some suggesting a deliberate attempt by bearish investors to sow doubt about a company’s financial condition and thus push up CDS prices, may have played a role. In the CDS market, a well-placed rumor of trouble, or snippet of negative analysis, can have an outsized impact on positions, because much like a put, the investor risks only the premium to control the action on a potentially large position. Buying CDS protection is the ultimate bear bet, and the incentive of CDS holders to accentuate the negative, particularly to the financial press, is almost irresistible.

This is why you should be concerned, and you might want to understand how the counterfeit value derivative con game works. It’s a game of “I pretend, you pretend, we all pretend, and the taxpayer pays in the end”. here’s how it goes:

1) I’ll create an instrument, a credit default swap (CDS); an unregulated insurance contract with no capital requirements, with a certain “notional” value. Notional value is just something I assign. It does not have to be attached to or backed by any real asset or actual money/principal, but I can pretend as if it is. (see http://en.wikipedia.org/wiki/Notional_amount)

2) As a seller, I will just declare that this swap covers the full value of a certain company,or contract, etc., if credit event Y happens. I receive lucrative insurance premiums and fees for my unbacked promise. The CDS’s value is based in nothing more than my promise to pay. I don’t have to have adequate capital reserves on hand, but I can pretend as if I do perhaps with some mini-reserves based on objective-seeming risk ratios calculated by my mathematical models. (see http://en.wikipedia.org/wiki/Credit_default_swap)

3) As a buyer, you can then buy as many of these CDS’s as you want, even for a single default. If you are really sure something is going to tank you can insure it 30 times over (or a 100 or 1,000) and get 30 (or 100 or 1,000) times the return when it goes bust! In regulated insurance, it is illegal to insure beyond the full replacement value of the underlying asset. Not so with CDS’s. The seller has gotten 30x the premiums and the buyer gets 30x the value in the event of default. As a buyer of this phony “insurance” you don’t have a stake in the affected properties, but you can pretend you do.

4) As buyer and seller of CDS’s, either one can assign our risks to a third party through another contract, and pretend as if we are covered in case our own game playing blows up in our faces. This allows us to retain even less reserve capital and spend freed-up funds on more high-risk, high-(pseudo) return speculation. (The monster that ate Wall Street.)

5) We can purchase and sell of these derivative contracts to each other at unlimited rates to generate massive volume and huge fees and profits. We can simply hyper-cycle risk and take our chunk each time. According to the Bank of International Settlements, as of June 2011, total over-the-counter derivatives contracts had an outstanding notional value of 708 trillion dollars, ( 32.4 trillion dollars in CDS’s alone). Where does this kind of money come from, and what does it refer to? We don’t really know, because over-the-counter derivatives are not transparent or regulated.

With regulated economic markets, when an underlying real asset is impaired (i.e. the company in question is bankrupt, the mortgage has defaulted, etc.), market value is assessed, default insurance is paid up to replacement or full value, bond holders and stock holders make claims on remaining value and the account is closed. There is no need for bailouts because order and proportion of compensation has been established and everything is attached to the value of the underlying asset.

When the unreal, counterfeit economy intrudes, we have a situation where a person can put in an unregulated, but recognized, claim to be paid a thousand times over, in case of impairment. Say market participants have negotiated for a bankrupt company a 70% payback for bondholders and 36% payback for insurance claims, and I come with not one but rather 1,000 CDS claims demanding to be paid for each CDS. Where does that money come from? Well, if it were regulated insurance, I would have to be invested in the company in some way, my bond or stock payout would be limited by the actual asset value of the company, and my insurance payout would be limited as well. However, since I am unregulated and unrestrained, the money due me has to come from the CDS seller and my contractual agreements with that company (say AIG). AIG could easily have sold 1,000 different unregulated insurance policies to the same person or a million CDS’s to a hedge fund, and when AIG could not pay up, it was threatened with insolvency, under which both its regulated and unregulated insurance policies and investments would become impaired.

In fact there is abundant evidence that hedge funds (i.e. Magnetar) did in fact multi-insure certain portfolios while simultaneously pressuring the portfolio managers to select risky investments to ensure that the portfolios would crash. This is the opposite of a traditional “stake,” and this is the disease that modern derivatives bring—profit from intentional market destruction. This chaotic state of affairs and its cascading implications for other interlinked parties and counterparties (read “too big to fail banks”), essentially resulted in economic extortion to force a huge public bailout of the whole crooked mess (totaling somewhere in the neighborhood of 10 – 14 trillion dollars in giveaways, loans and guarantees starting in 2008 in the U.S. alone.

Instead of agreeing to the extortion temporarily to prevent collapse and then aggressively pursuing orderly investigation, prosecution, and receivership, regulators and world leaders have simply covered up the events and even rewarded the perpetrators. No wonder the market goes up dramatically when there is talk about another quantitative easing (Fed bailout) or emergency rescue (government/taxpayer bailout). These financial game players already know that an open public spigot is on its way, pouring real capital directly into their pockets.

In regulatory actions and legal courts, unregulated insurance claims should simply be declared null and void when applied to real assets and real compensation. “You have no stake, therefore you have no claim. Your agreement was with a third party that did not have adequate capital to pay for a contract with you. Take them to court.” Or “You have an imaginary claim for imaginary damage. Here’s your imaginary money. Your deal was private and unregulated, then it should be settled in private between companies without public intervention or support.”

Did that happen? Of course not. AIG had collapsed and commingled its unregulated private and regulated public functions, and Congress had allowed it to do so years ago, with the repeal of the Glass-Steagall Act. Because the wall came down between regulated and unregulated activity, transparent and “shadow” markets, traditional and investment banking, this private fiat virus broke quarantine and the resulting contagion cannot be put back in the lab.

World leaders and their regulators blinked and did nothing, and the counterfeit private fiat (backed by nothing) has metastasized and infiltrated “genuine” public fiat (backed by our country’s productivity, if not by gold), and more and more actual money and productivity in the form of austerity is being thrown at a gargantuan and unrecoverable sea of counterfeit obligation. How can you exceed 700 trillion dollars in unregulated derivatives alone? It’s easy when market players are buying and selling from each other and when people can buy an infinite number of claims, insurances, and guarantees on credit events rather than assets.

When banks are allowed to mark-to-model and then claim somehow that their back-and-forth trading and abstract multiplication of asset value is real, then all bets are off (or “on” depending upon which side of the fence your sitting). Is it any wonder that the market for derivatives has grown another 100 trillion over the last two years? “Let’s see, I know. We’ll concoct value and you’ll pay us real money for it? Of course we are going to keep doing it! Why not another 100 trillion!” This probably is not going to stop until there is massive world-wide outcry and political change, a “black swan event,” or both. Let’s hope the first gains steam along with some long-overdue accountability for fraudsters, and some actual regulations are put in place to prevent another eruption, but the way Congress has behaved so far, it is hard to see how that would get done. Dodd-Frank? Your’e kidding, right?

A $100 trillion in derivatives in the last two years? Almost 50% more than at the height of the pre-crash in 2007?

Imagine what would happen if Greece takes the money from Germany, the IMF and the ECB, and then drops out of the Eurozone and defaults. Then, Italy says hey! Why should we stay in this thing, and then drops out and defaults as well, followed closely by Portugal, Spain and Ireland. All of those big banks co-partied to one another on all those worthless bonds and heavily positioned, once again, in derivatives. No underlying assets. And, the traders just keep on trading. Wow!

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About Steve King

iPeopleFINANCE™ Chief Operating Officer. Former CEO of Endymion Systems, Inc. a $36m Information Systems Services company. Co-founder of the Cambridge Systems Group, the creator of ACF2, the leading IBM Mainframe Data Center Security product; acquired by Computer Associates. IBM, seeCommerce, marchFIRST, Connectandsell alumni. UC Berkeley alumni. View all posts by Steve King

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