Credit Default Swaps: How To Blow Up A Financial System

Most folks on "Main Street" have heard the news about how Congress is attempting to regulate dangerous Derivatives, which are a financial instrument that derives its value from the price of an underlying asset. They know that abusive derivatives trading contributed to the financial crisis of 2008. They know that derivatives abuses brought down AIG, requiring the US government to loan them billions to remain liquid.

But most have never heard of Credit Default Swaps. If they have heard them discussed on the evening news, it's doubtful they actually understand what they are or how they have contributed to the financial mess the world finds itself in. And most do not realize that it was rampant CDS writing (selling CDS contracts) by 159 rogue traders at AIG, that resulted in bringing that huge insurance company to bankruptcy requiring the US taxpayer to bail them out and save the global financial system. CDS remain one of the most under-reported, mis-understood, financial instruments currently in existence.

The grievous problem of Credit Default Swaps is an issue I've been meaning to address for some time now. But it's a complex subject so I've held off until I had the time to properly address it. Rolling Stone is reporting on how the FINREG legislation, which was supposed to make these CDS transactions transparent, was effectively gutted and allowed Wall Street to resume "business as usual". Matt Taibbi, of Rolling Stone Magazine, has previously published a series of articles investigating Goldman Sachs and their involvement in the financial crisis of 2008

Wall Street's Big Win

But before you read that, here's some background on what a Credit Default Swap actually is.

Essentially, a CDS is unregulated financial "insurance" (though CDS traders go to great lengths to assert that it is NOT insurance). Two parties enter into a PRIVATE contract (not transparent to the market) buying and selling protection against the default of some underlying asset. HOWEVER, unlike typical regulated insurance, the two parties don't have to actually have an insurable interest in the underlying asset. These entities are known as "counter-parties" to that CDS contract.

Wikipedia gives a good explanation:

"A holder of a bond may “buy protection” to hedge its risk of default. In this way, a CDS is similar to credit insurance, although CDS are not similar to or subject to regulations governing casualty or life insurance. Also, investors can buy and sell protection without owning any debt of the reference entity. These “naked credit default swaps” allow traders to speculate on debt issues and the creditworthiness of reference entities. Credit default swaps can be used to create synthetic long and short positions in the reference entity.[4] Naked CDS constitute most of the market in CDS.[5][6] In addition, credit default swaps can also be used in capital structure arbitrage."

Edit: August 22, 2010: Here is an excellent article discussing the problems with developing a transparent clearing market for CDS derivatives, as well as CCP (central counter-parties) capital requirements and risks of oligopolistic (monopolistic) control over derivatives clearing.

The Sausage Marking begins..

CDS positions LACKING any insurable interest, are called "Naked CDS". They are essentially private BETS (eg: gambling) between two parties on whether an asset (that neither actually own) will default.

Now.. put that in terms that apply to each of in our daily lives. Imagine I'm able to purchase insurance on YOUR HOUSE, OR CAR, from a counter-party that will pay off if your house burns down. I don't own your house, nor am I a lender to you. But I'm able to purchase a "financial interest" in seeing your house burn down, or for your car to be stolen.

Naked CDS are like buying Fire Insurance on your neighbor's house

And even if I don't burn your house down in an act of direct arson, or sabotage your car, I can make you look like an incredibly poor credit risk by manipulated the cost of insuring your house. Supply and Demand for CDS would dictate the price of the insurance premium you pay to insure your own home. Therefore, if you have a thousand people demanding to buy insurance on your home, it would create the impression (to your insurer and bank) that you were ready to default at any moment, or that you were running a Meth lab in your home. Therefore, your insurance premiums would rise, and the perceived market value of your actual home, or just the mortgage note, would decline dramatically. All because a bunch of speculators have "ganged up" on you to make you look like trailer park trash to your creditors and insurers.

Thus, it's little wonder that participants in the CDS markets do not want them classified as insurance, let alone regulated as such. Because Insurance REQUIRES an insurable interest.

And, IN FACT, insurance was originally sold in a very similar manner to CDS. One didn't have to have an insurable interest to buy life insurance on another person. In effect, insurance PRIOR TO REGULATORY REFORM AND REQUIREMENTS was just a form of speculative gambling. Only by passing laws and regulations were these "surety bets" morphed into the actual insurance industry as we know it today.

But still the defenders of CDS parse words and split semantical "hairs" to keep them from being classified as insurance and requiring insurable interest in any CDS contract:

Repeat after me: CDS are not insurance

But the concept of such contracts not requiring insurable interest is nothing new.. Lloyds of London, once (or still are) the preeminent insurance entity, used to sell insurance on cargo ships to individuals lacking an insurable interest. It resulted in such an increase in insurance fraud (in the form of "accidental" sinkings, if not outright contracted piracy) that it resulted in Parliament passing the Maritime Insurance Act of 1746:

Maritime Insurance Act of 1746 Page 182

Legal Basis of Insurance: Insurable Interest

What's the bottom line about CDS?

Here's what the average investor has to think about. If powerful financial entities can purchase "insurance" via CDS on assets they do not hold, then they have every interest in seeing those assets devalue and default. At a personal level, if I wanted to force you and everyone on your block to sell your property to me so I could build a mall, all I would need to do is make financially intolerable for you to maintain your home insurance and mortgage. If you default on your mortgage, I own your house, as well as the property underneath it.

If I want to own your business or take you out as a competitor in the marketplace, I can round up a "cabal" of Naked CDS holders to devastate your perceived credit worthiness and make it untenable for you to issue debt for business expansion.

Now.. let's take this to the Sovereign debt level, what if I want to make your country's debt appear to be junk status? I get a bunch of my hedge fund buddies to buy CDS on your country's sovereign debt and force up the cost for you to insure and roll over that debt in the markets. This is what has happened with Greece and many of the other smaller, debt ridden states in Europe. As CDS premiums rise, so does the interest rate the market demands to roll over that debt. The only means by which a default can be prevented is for other nations (and their taxpayers) to front them money to "re-insure" that debt to prevent default.

Are you seeing the problem? To prevent sovereign collapse of their debt, taxpayers are put on the hook and money is "extorted" from them to prevent an even more grievous failure of the financial system. To prevent the collapse of both US and European banks considered "too big to fail", the US taxpayer was "blackmailed" into saving AIG and other banks via TARP. And then the Europeans were required to bail out Greece and (potentially) the other PIIGS at European TAXPAYER expense.

European CDS WMDs targeting Spain?

Now.. we have to ask ourselves, as common investors, why would we want to purchase ANY CORPORATE STOCK, OR DEBT, when such unregulated speculative FINANCIAL WEAPONS OF MASS DESTRUCTION are available to ATTACK the global equity and debt markets?

It's hard to imagine a better financial "tool" for transferring wealth from the masses (eg: taxpayers) to the few by destroying the value of their assets, whether equity or debt instruments.

It's also a fantastic tool for "supra-national" entities, or even sovereign countries, to conduct economic warfare to weaken their opponents and rivals, as well as sovereign states.

Heck, even China is now apparently being targeted by CDS speculators:

China CDS speculation rising.

This is why I've basically given up owning stocks for the long-term. I trade ultra-bull and ultra-bear ETFs and try to bank cash every day. And since Ultra-Bear ETFs are essentially CDS contracts on the underlying index, I recognize that, failing to "beat them", I've been required to join them... But I don't like the fact that I'm making money betting on the destruction of the US equity and financial markets, but right now that seems to be the only recourse left to me in an environment where our elected representatives are UNWILLING to regulate the CDS markets.

But destroy them they will, unless sovereign governments and their citizens DEMAND that they be regulated on a global basis, or outright banned as legally unenforceable contracts.

Scrutinizer

More reading on CDS and their financial impact:

Dissecting a Strange Financial Creature

CDS: Useful Risk Management Tool or Financial WMD?

Credit Default Swaps and Financial WMDs

CDS: The Monster that ate Wall St.

Pride Cometh Before The Fall?

Markets appear to be in a Rising Wedge formation during this period.

Rising Wedge Pattern

S&P daily chart

This is similar to the pattern that was observable (to the astute Technician.. ;0) back in April before the May "flash crash":

S&P 500 Rising Wedge during April, 2010

Also, I came across this link to a MUST READ Economic outlook that is predicting a recession in late 2010, early 2011. There are a lot of charts and discussion, but it should be understandable to even the layman out there.

The Future Recession In An Ongoing Depression (click on the embedded article for full screen viewing)

The primary crux of Pal's analysis is that the only economic growth we've had in the past year has been due to spending over a Trillion Dollars in government stimulus. Factor out that stimulus and it's evident that we're still in a recession/depression. It has NOT resulted in providing a buffer for GDP growth until the private market recovers.. The private market is still hunkering down, if not contracting, and they continue to lay off workers, therefore reducing consumer demand.

Now.. does that mean the market can't go higher? Again, I'm being VERY TACTICAL in my trading, and not yet betting on the "strategic turn" where I go all in and don't worry so much about trading, but more on riding the overall trend. It's coming, as all the fundamental data seems to indicate, but I don't want to be predicting the turn, but ready to be reactive when it finally manifests itself in a clear manner.

I see Christian from PSA is stepping out on a limb in predicting a sell-off prior to the Friday Unemployment report. The poor guy is STRATEGICALLY correct, but as for timing his swing-trade, he's obviously suffering a lot of pain.

Sell-off before Employment report?

I'm looking more at the SPX weekly chart with 100 Week MA for signs of ultimate direction to the market. It's going to lead every other US index.

Watch that MACD indicator.. If it continues upward in coming weeks, it's a powerful predictor of future price action.

Finally, I'm watching some of the currency turmoil we're seeing. The Yen is near a 15 year high against the USD and that is not a situation that can long continue without dramatic impacts on Japan's ability to export. Furthermore, the Euro has had a tremendous run since it's previous low of 1.18 against the USD. Part of what has apparently driven the US stock markets has been the decline of the USD.. Same can be said for oil and commodity prices, most of which are valued in USDs. The USD declines, the relative value of the stock and commodities markets appreciates. Watch for a reversal of this trend.

I often look at UUP, which is the USD bullish fund.. Plug it into the chart above and play around with it. Also, look at the VIX (VXX).. There is a new ETF that is the inverse to the VIX (XXV) that is going to be interesting to watch. The lower the VIX goes, the higher goes the equity markets.

That's all I have tonight.. Probably won't be trading tomorrow.. Got other obligations.

Scrutinizer

Signs of Impending Market Crash

I came across the link to this EXCELLENT SUMMATION of all the warning signs indicating another market crash. It's very readable to the layman, as well as the Technician.

Warning signs of impending market crash

Also, I get these emails from Stocktiming.com from time to time and they often include free charts. I'm currently contemplating a test subscription and will provide my review in a future post whether it's worth the money.

Anyhoo.. Marty Chenard brings up a VERY IMPORTANT point that helps us to analyze why the markets have performed they way they have. It has to do with "liquidity" in the financial system.

Do we have enough Liquidity in the system?

What's apparently from that chart is that the Fed was adding cash liquidity to the system at a breakneck past from March, 2009 up until April, 2010. They would drain ever larger amounts of liquidity, then ramp it up.. then drain even more.. Like weaning an Meth addict off a 12 month bender.. You can't do too much, without giving them a temporary fix.. but then you give them less and less.

However, just before the "Flash Crash" the Fed drained a ton of liquidity with the result that the market crashed. We've been fluctuating in "contraction" territory ever since then. But Chenard is telling us we're currently close to neutral and there are indications that the Fed is going to expand the money supply again based upon lagging economic data concerns.

No good "bringing down" the patient from his "addiction" if the result is that the patient dies as a result.

I don't know where Chenard gets his data on liquidity, but it does seem to show definitive correlations to market performance..

Can it be that easy? And doesn't that suggest that all market moves are "manipulated" by the supply of money in the system?

I'll have to do more reading on the subject and report back.

But in the meantime, be sure and read that article on "Warning Signs"..

And for your viewing pleasure, here's PSA's latest video on "exhaustion gaps".. It's a good lesson for aspiring Technicians to remember.

Exhaustian Gaps = Bear Market

Scrutinizer

Some Market Thoughts..

My apologies, beforehand, for any haste I show in putting this post together.

The Dow was up over 200 points today on the lowest ISM number since we "emerged" from the recession, but one that came in within estimates and still reflect positive economic growth.

Poor Christian, at PSA, failed to see the possibility of this low-volume uptrend being able to continue, despite his many short calls.. But this rally one can't be ignored, even though it's built upon flawed fundamentals and market technicals. It happened before during the period between January and April, and it appears to be happening again, potentially setting up for an October crash, which seems to be a favorite period for crashes.

Bulls can't win, Bears can't lose..

I actually agree with Christian, but I'm not as adamant about believing the crash is around the corner now. There are some financial "forces" at work that are hell-bent upon avoiding succumbing to bearish market readings.

And here is a look at global markets from Colin Twiggs who offers a free subscription to his excellent Technical Analysis insights:

Consolidation in a Bear Market

All of this economic data can be spun any number of ways, but the analyst must remember that it's based upon numbers that still include, BUT NOW ABSENT, government stimulus. And as the ECRI numbers (see below) indicate, we're ALREADY at a level where every other previous instance has resulted in recession. And any future data will reflect an economy not "juiced up" by government stimulus.

So I'm still not sold on a recovery, nor the resumption of a bull market.. No.. Not YET... This next two quarters will be the determining factor and we'll have to watch the weekly economic data before we're able to determine where we are.

But just because I'm not "sold" on recovery, not until I see the S&P 500 trading above 1250 which would quell fear of the Head and Shoulders, and set the index to revisit previous highs, AND we see positive trending economic and employment data. But it's hard to visualize such an event naturally occurring for the foreseeable future. And it's even more difficult to understand how this market has been climbing, on pathetic volume, and in the face of proven market indicators that suggest it's due for a 20% retracement and consolidation from it's March, 2009 lows. Even experienced market professionals are being whipsawed by this market action and it's undermining the public confidence in the equity markets.

But don't let it be thought that I want the market to continue crashing, or to live through another depression. I don't. I have NO INTEREST in seeing us slide into an economic hell. I only want to identify when it happens and protect myself, and my friends and family, from its effects.

And that's why I remain a short-term trader, buying and selling both ultra-bullish and ultra-bearish ETFs until we see some actual market and economic direction we can believe in. And many other investors are just selling out completely and hoarding cash. We've also seen hedge funds de-leveraging and standing on the sidelines waiting for direction.

But one thing that is paramount in avoiding recession, at least in the eyes of the Federal Reserve and Treasury dept, is that if consumers are not spending, a recession is nearly guaranteed. The velocity of money in the economy must be restored, as well as halting the de-leveraging consumer and debt defaults. If the "wind" (money) flowing through the economic "windsock" tapers off, then the economy will, like an actual windsock, sag and decline.

Now, I think there is significant evidence that would suggest that the value and direction of the stock market is critical to impacting the psychology of the average consumer, especially if their 401Ks have basically "flat-lined" for the past 12 years.

So.. is it possible that the Fed has been either directly buying, or facilitating the purchase by banks/institutions, of equities and equity futures, in order to ward off the insidious Head & Shoulders formation that I've been discussing and restore investor confidence, and therefore, consumer confidence?

Actually, this is not a new thought.. There was some commentary back in March from the CEO of Trimtabs, a VERY REPUTABLE firm that tracks all kinds of market data suggesting that the markets are being rigged by the Fed (or someone):

Who's buying the market?

It's frightening (to me) when such a reputable firm starts to question the independence of the markets from Fed/Gov't interference. And recall that this was BEFORE the "flash crash" of May 6th when investor money REALLY started flowing out of the markets.

Here's another article that discusses the global banking systems increases in Money supply over the past year. And it suggests that this is, in good part, reason for why the stock markets haven't crashed.

Money Supply expanding?

But that's also called a HUGE "moral hazard", if not a huge violation of the concept of "Free Markets" which could quickly ignite major inflation if people start believing the Fed and other Central Banks are effectively putting a floor under equity prices.

There's also another possibility, for which I have absolutely no evidence, but could explain why the Fed would be tempted to take the unprecedented step of intervening in our equity markets. Could it ALSO be that our markets have been under attack by foreign sources/governments via Credit Default Swaps? Could it also be that these "supra-national financial forces", only holding loyalty to profit, also attacked European based financial interests via our own CDS attacks against European debt? This is a theory that I've been trying to accumulate evidence for ever since I finally understood the destructive nature of CDS as a financial instrument.

Since CDS make perfect financial "weapons" due to their nature as "private contracts" not transparent to the rest of the markets, their use can be perceived as a national security threat. And such an attack could necessitate an active defense of our financial system and equity markets until such instruments are fully regulated and controlled (supposedly via "FINREG").

Here's another article comparing the housing bubbles in other parts of the world compared to the US. We weren't the worst, but given what the US is enduring, it will be not be very pretty as these other bubbles get popped.

Global Housing bubble choking World banking system

And Mish had some discussion of the under-reported (didn't see it on any business news websites or broadcast) ECRI data that's indicating we're set for another recession. Remember "double-dip" is essentially the same as a Depression.. They just don't want to call it that until the history books are written.

ECRI data is negative, practically guarateeing another recession

So.. the bottom line is that while the economic data doesn't support a higher stock market price at this time, it's likely we're going to get it for the foreseeable future because the "powers that be" refuse to let the markets fall.

The question is how long they can keep up this charade without publicly revealing their hand?

That's all for now..

Scrutinizer