The $55 trillion question: Will this be the next disaster?

Yesterday we learned that our big banks ignored sub-prime troubles

What I didn’t raise was another article by SMH’s Michael West exposing another major potential liability that banks face, that to date, has gone largely unnoticed.  West writes:

Australia’s Big Four banks are all exposed to the default of Lehman Brothers via credit default swaps (CDS) – a noxious bull-market derivative which threatens further contagion in the ailing global financial system.

National Australia, ANZ, Westpac, Commonwealth Bank and the nation’s biggest insurer AMP are listed on the ISDA’s (International Swaps and Derivatives Association) Lehman Protocol. The five have written “adherence letters” to the ISDA asking the Association to act as their agent in settlement negotiations arising from the Lehman default.

This Wednesday is the deadline for lodging settlement notices for CDS trades and October 20 is the date for settlement.

Little known is the fact that the amount at stake in the credit default swap [CDS] market is actually greater than the world’s annual economic output.

In fact, On the 30th of September, Fortune Magazine asked the question:

The financial crisis has put a spotlight on the obscure world of credit default swaps [CDS] – which trade in a vast, unregulated market that most people haven’t heard of and even fewer understand. Will this be the next disaster?

As Congress wrestles with another bailout bill to try to contain the financial contagion, there’s a potential killer bug out there whose next movement can’t be predicted: the Credit Default Swap.

In just over a decade these privately traded derivatives contracts have ballooned from nothing into a $54.6 trillion market. CDS are the fastest-growing major type of financial derivatives. More important, they’ve played a critical role in the unfolding financial crisis. First, by ostensibly providing “insurance” on risky mortgage bonds, they encouraged and enabled reckless behavior during the housing bubble.


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9 Responses

  1. Well the markets seem to be enjoying a bounce:

    Stocks bounced back from their worst week ever with one of their best performances in history as investors cheered a global cash infusion designed to unthaw the credit market and avoid a global meltdown.

    The Dow Jones Industrial Average gained about 950 points, or more than 11 percent.

    It was the biggest point gain in the Dow’s history — nearly double the prior record of 499.2 points set back in 2000 — and the biggest percentage gain since 1933.

    The S&P 500 and Nasdaq gained nearly 12 percent.

    Markets in Asia advanced, while markets in Europe rallied 10 percent, their biggest one-day percentage gain on record, after major central banks pledged to lend unlimited amounts of dollars to commercial banks to unfreeze credit markets and after the U.K. announced plans to bail out three major banks — Royal Bank of Scotland, HBOS and Lloyds.

    Monday’s rally helped the Dow claw back about half of the 1,874, or 18 percent, it lost last week. That was the worst point and percent drop in market history.

    After the stomach-churning drops of recent weeks, a curious byproduct: Traders are actually saying openly that the bottom is in. Typically, no one wants to be within a 500-mile radius of calling the bottom.

    “We’ve gone through three or four layers of what I thought was the bottom,” said David Bianco, chief U.S. equity strategist at UBS Investment Research. “Does it get any worse than last week?” he asked. “If that wasn’t it last week, I don’t know what was,” he said.

    The ASX is up 6% percent this morning.

  2. It’s all part of the major shakeout Reb

    The of free market theory is finally up for a major review, I agree with Henry.

    “This crisis will test economic theory, regulatory systems and the general role of government as nothing has done since the catastrophe of the 1930s.”

    http://www.theaustralian.news.com.au/business/story/0,28124,24487251-5013868,00.html

    “GOVERNMENTS working on their own have failed to stem the crisis, now we find out if governments working together can do any better.

    What is certain is that private financial institutions working in history’s most developed markets, the global financial system, has failed to solve the crisis.

    The theory, one assumes is that overexposed households and banks should have failed and prudently managed households and banks should have prospered.

    Apparently no one, not even the supposedly free market Bush administration was prepared to try the theory.

    Ironically it was the willingness of the USA to allow Lehman Brothers to fail that is being fingered as the key decision, that turned a crisis into a global catastrophe.

    This is despite the bailouts of Fannie and Freddie, AIG and the forced marriages of Bear Sterns and many other failed financial institutions.

    It is easy to blame the existing regulatory system for the problems, plus 30 years of consumerism, fuelled by exponential growth of debt, asset inflation and a progressive weakening of standards of credit evaluation.”

  3. It’s certainly a real and growing concern

    The Next Banking Bomb?
    CBS News Investigates: Credit Derivatives Comprise $54.6 Trillion Of Risk Among Few Banks Left Standing

    October 10, 2008
    “This bill will, in my judgment, raise the likelihood of future massive taxpayer bailouts. …if you want to gamble, go to Las Vegas. If you want to trade in derivatives, God bless you.”

    That was North Dakota Senator Byron Dorgan’s statement on the floor of the Senate – not this week or last, or even during the last six months as Wall Street collapsed – but back in 1999.

    Four years later in a letter to shareholders, billionaire investor Warren Buffett followed with his own warning, calling derivatives “weapons of financial mass destruction” controlled by “madmen.”

    While financial experts were concerned with the housing bubble and mortgage-backed securities, Dorgan and Buffett were focused on what many now believe may be the next big shoe to drop – the credit derivatives market, better known as credit default swaps.

    What worries financial insiders most is the $54.6 trillion of risky credit derivatives concentrated among the few banks left standing.

    Credit default swaps (CDS) are the cornerstone of the credit derivatives market accounting for more than 98 percent of all credit derivatives. They are difficult to understand, ignored by regulators and poorly reported on balance sheets. In simplest terms, CDS are insurance policies on things like bonds, loans and corporate debt. But there are two big differences: the seller of a CDS doesn’t need to have the money to cover losses if the security defaults, and the buyer doesn’t need to own the asset it wants to protect.

  4. Actually John,

    I’ve received an article (pdf) from the NY Times dated 1999 talking about Fannie Mae being financially exposed. I can email it to you if you like..

    It warned that the Govt may have to bail them out..

    AND THAT WAS BACK IN 1999…!!

  5. Thanks Reb, It would be appreciated. I find it amazing, just like the Howard Government were aware of the pending housing debt disaster in 2003, that government officials everywhere ignored the warnings.

    I think it gets back to what Galbraith was saying about the 1929 crash:

    …now, as throughout history, financial capacity and political perspicacity are inversely correlated. Long-run salvation by men of business has never been highly regarded if it means disturbance of orderly life and convenience in the present. So inaction will be advocated in the present even though it means deep trouble in the future. Here, at least equally with communism, lies the threat to capitalism. It is what causes men who know that things are going quite wrong to say that things are fundamentally sound.”

    Yes, it’s the old ‘fundamentally sound’ spin in play.

  6. Communism : The government owns everything.
    Capitalism: Big Business owns everything.

    The only difference that I can see is that communism has usually come about through bloodshed. While capitalism big business concentration has come about through takeovers and buyouts.

    We need an alternative that allows capitalism to operate within a social framework.

  7. We need an alternative that allows capitalism to operate within a social framework.

    I agree Shane, as Soros has pointed out:

    “Capitalism is very successful in creating wealth, but we cannot rely on it to assure freedom, democracy and the rule of law. Business is motivated by profit: it is not designed to safeguard universal principles. Most business people are upright citizens: but that does not change the fact that business is conducted for private gain and not for public benefit. The primary responsibility of management is to the owners of the business (and more often than not, themselves), not some nebulous entity called public interest – although enterprises often try, or at least pretend to be acting in a public spirited way because that is good for business. If we care at all about the universal principles such as freedom, democracy and the rule of law, we cannot leave them to the care of market forces: we must establish some of the institutions to safeguard them.”

  8. My prediction – nothing will change…

    Governments are too controlled now by business (the Robber Barons) and have been lost by the people (serfs and peasants)…a simple example is the politicians perks after they resign – try changing the government superannuation scheme to match the pleb’s – virtually impossible…

    The world is run by multi millionaires – that should tell you something – in Australia’s case Rudd’s goal is the UN – Turnbull’s is commercial development – his own…

  9. John

    We also needs governments with some balls standing up to these CEOs and staring them down when they run around screaming that the economy will collapse if they don’t get their own way on everything as eems to be the case these days.

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