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Credit Default Swaps: The "Gordian Knot" Standing in the Way of Economic Recovery

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In an article by Joe Nocera entitled “Propping Up a House of Cards” appearing in the print edition of the New York Times on February 28, 2009 (and in his “Talking Business” column in the web edition), we learn that “credit default swaps” are the root problem.  Here are a few noteworthy passages:

“Next week, perhaps as early as Monday, the American International Group is going to report the largest quarterly loss in history. Rumors suggest it will be around $60 billion, which will affirm, yet again, A.I.G.’s sorry status as the most crippled of all the nation’s wounded financial institutions.”

“So far the government has thrown $150 billion at the company, in loans, investments and equity injections, to keep it afloat.”

“A.I.G. effectively has been nationalized, with the government owning a hair under 80 percent of the stock. Not that it’s worth very much; A.I.G. shares closed Friday at 42 cents.”

“[It has been predicted] that A.I.G. is going to cost taxpayers at least $100 billion more before it finally stabilizes.”

“If we let A.I.G. fail, said Seamus P. McMahon, a banking expert at Booz & Company, other institutions, including pension funds and American and European banks ‘will face their own capital and liquidity crisis, and we could have a domino effect.’ A bailout of A.I.G. is really a bailout of its trading partners — which essentially constitutes the entire Western banking system [emphasis added].”
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“More than even Citi or Merrill, A.I.G. is ground zero for the practices that led the financial system to ruin.”

Practices?  What practices?  Well…

“[M]ost of A.I.G. operated the way it always had, like a normal, regulated insurance company. But one division, its ‘financial practices’ unit in London, was filled with go-go financial wizards who devised new and clever ways of taking advantage of Wall Street’s insatiable appetite for mortgage-backed securities. Unlike many of the Wall Street investment banks, A.I.G. didn’t specialize in pooling subprime mortgages into securities. Instead, it sold credit-default swaps [link provided by NYTimes].”

Credit default swaps (CDSs) is a terminology that is not yet widely seen in the mainstream media.  And from the speeches I’ve listened to, CDSs don’t seem to have been mentioned by President Obama either.  Does this mean that CDSs are unimportant?

Au contraire, CDSs are at the root of why the present economic crisis cannot be solved solely by means of “bailouts” or “stimulus plans.”  How do I know?  Because I’ve read some authoritative articles on the subject [for example here, here, and here] well before the NYTimes put up Joe Nocera’s link above.  And one of the things I’ve learned is that the notional value of all known CDSs is now in excess of $ 500 trillion (half a quadrillion dollars!) – or about 10 times the value of all the world’s stock and bond markets combined!  These debts literally can NOT be paid, at least not without debasing most of the world’s currencies by factors of one tenth to one hundredth of their present values.

How can this possible?  Well, it’s because the market for derivatives (famously termed by Warren Buffet “financial weapons of mass destruction”) has operated over-the-counter – totally unregulated – for the past decade.  Eventually, hedge funds placed binding “bets” that the real-estate bubble would never stop inflating.  These bets took the form of CDSs, which are essentially insurance policies on the by-now-well-known collateralized debt obligations (CDOs).  (Reminder: CDOs are sliced and diced bundles of largely-toxic, largely real estate debt instruments.)

Now that the real-estate bubble has burst, the present owners of those CDSs are demanding to be paid their due – which, to repeat, adds up to as much as 10 times what the world’s stock and bond markets were worth before the beginning of the present market slide!  To actually pay off all of this “debt” would mean creating a small number of trillionaires at the expense of wiping out the entire world’s financial system, and the world’s middle class along with it!

So is there no way out?  Well, no one else has publicly proposed one yet, so let me take a crack at it.  I suggest that all of the developed countries of the world whose banks – and whose insurance companies like A.I.G. – are facing CDS-derived losses far exceeding their net worths should summarily nationalize all such at-risk banks and insurance companies.  Then all of these countries (especially the U.S.!) should promptly declare NATIONAL bankruptcy.  Whereupon, bankruptcy courts would negotiate payments to all current holders of the CDSs, likely amounting to just a few cents on the dollar.  Once this is process is completed, these countries would be free to restart their economies the old fashioned way: Commercial banks would accept deposits in return for interest payments and would use these deposits to make properly collateralized loans to responsible individuals and businesses.  Investment banks may rise again, but not without the kind of government regulations that might have saved us from the present crisis.
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Ph.D. in Physics, Brown University, 1966. Fellow, American Physical Society. Fellow, American Association for the Advancement of Science. Fellow, American Ceramic Society. Research Physicist at Naval Research Laboratory (NRL), Washington, DC, (more...)

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The notional value of all CDS outstanding is not $... by Nick Jones on Monday, Mar 2, 2009 at 10:22:13 PM
I had no idea these numbers were so accessible.&nb... by David Griscom on Tuesday, Mar 3, 2009 at 12:29:09 PM
What's really amazing is the the quarterly los... by Roger Thomas on Tuesday, Mar 3, 2009 at 3:20:19 PM
Dr. Griscom,Thank you for bringing up this crucial... by George Washington on Tuesday, Mar 3, 2009 at 5:46:03 PM
Thank YOU!  I only wish I'd seen you post... by David Griscom on Tuesday, Mar 3, 2009 at 7:11:22 PM
AIG is paying big money to the offshore hedge fund... by Arktig Silver on Tuesday, Mar 3, 2009 at 8:42:35 PM
I did not know this was going on. Thanks for provi... by allen lemoine on Wednesday, Mar 4, 2009 at 1:51:03 AM
This is a very valuable contribution to the proble... by Michael Collins on Wednesday, Mar 4, 2009 at 2:52:48 AM
Yes, manipulation have been there for a long time.... by Arktig Silver on Wednesday, Mar 4, 2009 at 9:59:17 AM
Michael, I see that you too have returned to quoti... by David Griscom on Wednesday, Mar 4, 2009 at 10:28:25 AM
Casino bets should not be insured, neither by AIG ... by Arktig Silver on Wednesday, Mar 4, 2009 at 12:05:12 PM
Man this guy must be a horrible law professor if i... by dan b on Wednesday, Mar 4, 2009 at 3:45:03 AM