Financial Derivatives – CDSs & CDOs: How Big Is the Financial Mess?

[NOTE: Today’s news:  bondholders with derivatives force GM towards bankruptcy. How many more companies might this happen to?]

According to Ira Glass’ “This American Life” program on NPR, the scope of the financial problem is as big as that huge 100 foot wave in the movie, “The Perfect Storm.” The title of the NPR show is “Another Frightening Show about the Economy.”  Included is a terrific section on derivatives, specifically the type of derivatives called credit default swaps (CDSs). [minutes 20-40 of Oct. 3-5 episode 365 on]

Credit default swap derivatives (CDSs) were bought and sold by AIG, the five giant investment banks, other big banks, hedge funds, pension funds, mutual funds, and corporations. Just about every large financial institution had a “derivatives desk.” If you wanted to buy one of these “insurance policies,” you had to have at least $5 million in your accounts.

What is a derivative? For a derivative to exist there first has to be a financial transaction. A financial transaction is an exchange between two people or “parties.” The exchange usually involves one party buying and one party selling something, For example, a company or municipality sells its bonds to a buyer (called a bond shareholder.) A derivative sits on top of that underlying financial transaction. Supposedly it “derives” from the underlying transaction. In the case of many CDSs, that connection was exceedingly remote.

CDSs are legal, but unlike ETFs, they are not sold on the stock exchanges. They are private deals and completely unregulated—because Congress voted not to regulate them. When the SEC head finally asked them to regulate CDSs, Congress essentially said “These rich guys are sophisticated investors and smart. They wouldn’t screw up.”

Amazing as this seems given that CDS derivatives are essentially based on nothing more than the reputation of the company buying or selling them, even some regulators at the SEC and financial reporters didn’t seem to understand the dangers. Whenever credit swaps were discussed in the newspapers they were called “insurance” or a “hedge” against risk.

CDSs did start out as a form of insurance. You went to an insurance company like AIG or a big bank and you bought  “insurance” against one of your investments going bad, say an investment in a company’s bonds. If the bonds went bad, your insurance paid you.

But then people began hedging with CDSs. They went so far as to buy CDS “insurance” on investments they didn’t own! If the investment became shaky, you could sell your “insurance policy” to another buyer for a higher price than you paid for it. If the investment completely defaulted, your “insurance policy” paid you. But if the investment stayed OK, you could still sell your “insurance policy” on it and lose no money. This is how CDS “hedges” were used for speculating.

The problem with CDSs is, that unlike regulated insurance policies, companies that sell CDSs don’t have to have “capital reserves” on hand to cover them. As companies started having credit problems from the mortgage mess, they also started having headaches from the CDSs they sold. With no short term credit available to borrow, AIG just couldn’t pay off the billions it owed on its CDSs.

Financial institutions panicked. When the economy started going badly, banks stopped trusting each other because no one bank knew how many CDSs (and other speculative investments) any other bank was in hock for. So, in reality, derivatives like CDSs didn’t protect against risk. They increased it!

The horror isn’t just that an estimated five trillion dollars worth of CDSs were issued. The horror is that there was “leveraging” (buying and selling investments without having all the money on hand if called on to fulfill their contractual promises to pay). Leveraging caused the total amount of money tied up in CDSs to eventually become $60 trillion! But that’s just part of what the bailout has to deal with.

Add in tens of trillions more for failing “whole” mortgages. Then add hedging done with another kind of derivative, CDOs (collateralized debt obligations). CDOs are mortgages mixed up together and then cut up into up investment pieces called tranches. The result of using CDSs and CDOs? You get the perfect financial storm.  The ensuing gigantic financial wave coming at us could run as high as 100s of trillions of dollars.

Do we think a little more than just one-half of one trillion dollars for the bail-out can go very far towards de-leveraging or “unwinding” that huge of a “toxic” debt? Not unless Hank Paulson of the Treasury and Ben Bernanke of the Federal Reserve are wizards worthy of a position at Harry Potter’s school! That’s what’s truly scary.

Copyright © 2008 by Nancy K. Humphreys