06 May 2008

Financial Madness: Credit Default Swaps

This probably is not the blasting cap that will ignite the US financial system, since Fannie is obviously too big to fail by a number of measures above and beyond the potential impact to the Credit Default Swaps Market. But the day will come when something will ignite the debt bomb that the global banks have built.

Fannie Mae's credit default swaps widen 16 pct
Tue May 6, 2008 9:07am EDT

NEW YORK, May 6 (Reuters) - The cost of protecting Fannie Mae's debt with credit default swaps rose about 16 percent on Tuesday after the provider of U.S. home financing posted its third straight quarterly loss.

Five-year credit default swaps on Fannie Mae rose to about 50 basis points, or $50,000 a year to protect $10 million of debt, up from about 43 basis points on Monday, according to data from Markit Intraday.
Reporting by Dena Aubin; Editing by Theodore d'Afflisio

The problem seems so obvious. Swaps and instruments based on spreads were a useful way to manage risk. However, over time the banks started playing just the spreads themselves, and the amount of arbitrage over individual groups of bonds' risk has become as disconnected from the underlying reality of the marketplace as placing a wager on black or red in roulette. At some point they just started playing the numbers and let the real economy go to hell.

The banks have piled on an enormous amount of leveraged speculative BETS that have little or nothing to do with the actual business of loaning money and allocating capital, and using the deposits of the saving public wisely.

The banks are feeling safe using VaR (Value at Risk) to measure their exposure. The use of this measure of trading risk has a number of fatal assumptions built into it reminiscent of the portfolio insurance mania that preceded the Crash of 1987. Counterparties remain viable, markets remain liquid, normal distribution of the bell curve.

Why would they do this? Because as the dealers, the croupiers, they take a piece of the action, their percentage of every pot, and put it into their pockets as long as the play continues and the game remains in motion.

The nasty little secret is that they are not playing with their own money; they are playing with yours. They don't care if you lose as long as they get their percentage. Beyond that, they are not thinking that far ahead.

It was giving them access to the insured deposits of the nation and allowing them to take the nation's wealth to the gaming tables that set the wheels of this casino in motion. It was the repeal of Glass-Steagall.

In the short term they have power, real power, to make prices do what they wish them to do.

This will begin to cause havoc in the real world as price distortions create shortages and oversupplies. The price discovery mechanism of the markets is in their control for now. But when the day comes that the markets revert to the mean, when rude reality intrudes, we are going to see price gyrations, both up and down, that are going to seem astounding, impossible, unbelievable, and potentially devastating.

This is not a financial system operating responsibly. This is not even gambling. This is Madness because the wagers can never clear, they can never all be paid. The derivatives market has become a kind of semi-psychotic preoccupation with itself and a mathematical world of its own creation.

People will look back AFTER the crash and say, 'how could they have allowed this to happen?'

Here are some examples of how out of control and disconnected from reality the banks have become?