In the mid-80s, I ran a private partnership – call it a hedge fund – from the floor of the Chicago Board of Options Exchange Inc. (CBOE). I was an independent market maker, meaning I could walk into any trading pit on the floor and trade any options and any stocks.

I knew the stocks I traded very well. I knew my capital and leverage. I gauged the psychology of the crowd.

My plan was to cause the stock to drop, triggering the locals and others to panic out of their positions. They would sell their calls and if the price of calls fell too quickly, they would start buying puts to hedge themselves. As the stock fell and the price of puts rose higher and higher, guess who would be selling the locals puts?

Since I had bought a lot of puts and their price was rising, I would leave the crowd and have a broker in the pit sell my now-profitable put position to the eager crowd.

I am a trader. That’s my job. I trade to make money. That’s my job. That’s what everyone else does. But I succeeded much more often than most of the traders I competed against – because I followed these four basic rules of trading:

• I knew the instruments I was trading.
• I knew my capital and leverage limitations.
• I was able to gauge the psychology of the market.
• And I had a plan that I always followed.

Unfortunately, the story is much different for the U.S. Treasury Department, under the command of Treasury Secretary Henry M. “Hank” Paulson Jr., and the U.S. Federal Reserve, under the command of Chairman Ben S. Bernanke. Although these two top Bush Administration officials are the key architects of the bailout plan that’s being deployed even as you read this, they have violated all four of those basic trading rules. In short, neither of these two key officials:

• Has proven his grasp of the complexity of the instruments causing the credit crisis.
• Understands the extent of leverage used by the players who are central to this financial mess.
• Grasps the psychology of the markets.
• Or has a workable plan to fix the problem at hand.

The Genesis of a Global Financial Crisis

The Treasury and the Fed have several problems. First, they don’t understand the instruments that are at the root of this crisis. The complexity of collateralized mortgage-backed securities (CMBS) is beyond any simple explanation, though I offered one a few weeks ago. Second, and exponentially worse is that there is a “multiplier catalyst” in this devastating deleveraging and worldwide slaughter that isn’t understood, and isn’t regulated – by anyone.

I’m talking, of course, about credit default swaps.

Yes, collateralized mortgage-backed securities are at the bottom of the crisis. But, the frightening truth is that we can’t even get to them because they are covered so completely by what I’m calling the multiplier catalyst – credit default swaps. I also have offered a simple primer on credit default swaps.

These two instruments collided when traders wanted to either hedge their CMBS positions, or when they sought exposure to mortgage-backed securities, either by mimicking being long them or, in effect, shorting them. A credit default swap is a bilateral contract between, for example, you and me, under which we agree to a deal to insure a position you have because you own these dreaded CMBS. You agree to pay me a premium, up front and yearly, for the next five years. And I agree that if the CMBS you own defaults, I will pay you its full value. This is a good deal for you, right?

In fact it’s such a good deal that you ask me if I’ll insure you for the value of several different companies’ bonds and debts, in case they default. I agree. Pay me my premiums, please.

Your friend, who doesn’t own any CMBS, hears about the deal and asks me to insure them if the same CMBS securities default, even though they don’t own any themselves. I agree.

Pay me my premiums, please.

It didn’t matter to you that I’m not an insurance company. It didn’t matter to you that I never set aside any capital to pay you in the event that the instruments I was insuring you against actually did default. It’s a game – a trading game. Get it?

Unfortunately for the worldwide financial markets, I’m not the only one to play this game. Real insurance companies, investment banks, hedge funds, banks and lots of others have played this game. And, there’s a caveat. A big one.

All the bilateral contracts have a provision for margin to be posted; that is, collateral must be posted by me, or by American International Group Inc. (AIG), if they wrote these virtual-insurance-contracts and they start to go against us … which means that those instruments we insured actually might go into default.

AIG was bailed out to the tune of $80 billion, because it had margin calls on CDS contracts it wrote. Do you know why they now need an additional $38 billion in help? Because they are experiencing more margin calls on their credit default swaps. The Treasury and Fed never understood these instruments, let them run wild and now we are all paying the price.

That’s the story, but – as always – there’s also the story behind the story.

The leverage that was employed when CMBS and CDS contracts were bought and sold is not even known. How much did banks, investment banks, insurance companies, hedge funds and traders borrow to initiate their trades?  There are no accurate figures and not even any accurate estimates.

Now we come to the psychology of the market. No one – save my new idol, hedge-fund-manager extraordinaire and mega-billionaire John A. Paulson (who deserves every penny he made) – understood what “the crowd” was thinking. What they were thinking was that housing prices aren’t going to fall, companies aren’t going to default, and everything is under control because we’ve all calculated our Value at Risk and go merrily skipping along.

We’re not going to be okay because the plans that Treasury and the Fed have put forth weren’t plans to begin with. They are reacting, moment-by-moment to the markets.

With all due respect to Interim Assistant Secretary for Financial Stability, Neel Kashkari, he’s a “rocket scientist” and not a trader. And it was the rocket scientists who devised these securities for traders in the first place and neither group ever understood the instability and combustibility of the solid rocket fuel they were mixing. How is it possible for the talented Kashkari to gauge the markets and traders worldwide, when he’s never traded anything?

The global contagion is the direct result of margin calls that seeminglycrosses every security type (especially credit-default-swap positions), in very market, and seemingly in every country.

And the worst of it? As companies’ stock prices fall, as the value of their bonds fall and their debts mount, as they get closer and closer to actual default, the sellers of credit default swaps are getting bigger and bigger margin calls. Everyone is selling whatever they have to meet margin calls. It’s a worldwide de-leveraging – to an extent that we’ve never before conceived.

The Only Real ‘Exit Strategy’

Enough bad news. There is a way out: Shut down the CDS market. Net out all existing positions. Cancel contracts. Let CMBS holders keep their positions. And here’s why: There’s not enough money in the Treasury plan to buy them all up. Adjust the cost accounting basis on the books of holders so that they don’t have to mark those securities down. Give the Fed and Treasury unlimited transparency into every financial firm’s books on a strictly private basis and let them manage, merge and close down the insolvent “basket cases,” while guaranteeing every depositor in every bank and money-market fund.

And there’s more. Provide incentives for depositors and investors to stay with salvageable institutions by eliminating any capital gains on net new investments into these government-backstopped institutions.

Who are we kidding? Fannie Mae (FNM) and Freddie Mac (FRE) insure most of the troubled mortgages already. And that means the government. So allow all mortgages – after a certain date – to be refinanced by healthy banks whose cost of funds to make new loans should come directly from the Treasury at the Federal Funds rate. This will allow banks that write new loans to make them cheap and still have good profit margins. Make those homeowners pay back the favor by sharing the appreciation on those homes with the taxpayers who bailed them out, when they sell them.

Also absolutely necessary: Make key cuts. Cut taxes. And cut all wasteful government spending on all earmarked and pork barrel projects.

And last, but not least, put all the lobbyists in jail – especially the former legislators and their staffs who sold the American people short just to feed their own disgusting greed and avarice.

News and Related Story Links:

• Wikipedia:
  Federal Funds Rate.
• Money Morning Market Analysis:
  By Relaxing “Mark-to-Market” Rules, Has the U.S. Switched Off its Financial Crisis Early Warning System?
• AllExperts.com:
  Using Banks and Bank Accounts; Cost of Funds.
• Wikipedia:
  Mortgage-Backed Securities.
• Wikipedia:
  Commercial Paper.
• Reuters Financial Terms Glossary:
  Matched Book.
• Wikipedia:
  Discount Window.
• Wikipedia:
  Term Auction Facility.
• Wikipedia:
  Federal Deposit Insurance Corp.
• Money Morning News:
  Federal Reserve to Buy Commercial Paper to Free Up Frozen Market.
• Wikipedia:
  Federal Open Market Committee.
• McClatchy Newspapers:
  Fed’s half-point rate cut proves no match for Wall Street’s fear.
• About.com/Investing for Beginners:
  What is a Market Maker and How do Market Makers Make Money?

Back to Archive

In the mid-80s, I ran a private partnership – call it a hedge fund – from the floor of the Chicago Board of Options Exchange Inc. (CBOE). I was an independent market maker, meaning I could walk into any trading pit on the floor and trade any options and any stocks.

I knew the stocks I traded very well. I knew my capital and leverage. I gauged the psychology of the crowd.

My plan was to cause the stock to drop, triggering the locals and others to panic out of their positions. They would sell their calls and if the price of calls fell too quickly, they would start buying puts to hedge themselves. As the stock fell and the price of puts rose higher and higher, guess who would be selling the locals puts?

Since I had bought a lot of puts and their price was rising, I would leave the crowd and have a broker in the pit sell my now-profitable put position to the eager crowd.

I am a trader. That’s my job. I trade to make money. That’s my job. That’s what everyone else does. But I succeeded much more often than most of the traders I competed against – because I followed these four basic rules of trading:

• I knew the instruments I was trading.
• I knew my capital and leverage limitations.
• I was able to gauge the psychology of the market.
• And I had a plan that I always followed.

Unfortunately, the story is much different for the U.S. Treasury Department, under the command of Treasury Secretary Henry M. “Hank” Paulson Jr., and the U.S. Federal Reserve, under the command of Chairman Ben S. Bernanke. Although these two top Bush Administration officials are the key architects of the bailout plan that’s being deployed even as you read this, they have violated all four of those basic trading rules. In short, neither of these two key officials:

• Has proven his grasp of the complexity of the instruments causing the credit crisis.
• Understands the extent of leverage used by the players who are central to this financial mess.
• Grasps the psychology of the markets.
• Or has a workable plan to fix the problem at hand.

The Genesis of a Global Financial Crisis

The Treasury and the Fed have several problems. First, they don’t understand the instruments that are at the root of this crisis. The complexity of collateralized mortgage-backed securities (CMBS) is beyond any simple explanation, though I offered one a few weeks ago. Second, and exponentially worse is that there is a “multiplier catalyst” in this devastating deleveraging and worldwide slaughter that isn’t understood, and isn’t regulated – by anyone.

I’m talking, of course, about credit default swaps.

Yes, collateralized mortgage-backed securities are at the bottom of the crisis. But, the frightening truth is that we can’t even get to them because they are covered so completely by what I’m calling the multiplier catalyst – credit default swaps. I also have offered a simple primer on credit default swaps.

These two instruments collided when traders wanted to either hedge their CMBS positions, or when they sought exposure to mortgage-backed securities, either by mimicking being long them or, in effect, shorting them. A credit default swap is a bilateral contract between, for example, you and me, under which we agree to a deal to insure a position you have because you own these dreaded CMBS. You agree to pay me a premium, up front and yearly, for the next five years. And I agree that if the CMBS you own defaults, I will pay you its full value. This is a good deal for you, right?

In fact it’s such a good deal that you ask me if I’ll insure you for the value of several different companies’ bonds and debts, in case they default. I agree. Pay me my premiums, please.

Your friend, who doesn’t own any CMBS, hears about the deal and asks me to insure them if the same CMBS securities default, even though they don’t own any themselves. I agree.

Pay me my premiums, please.

It didn’t matter to you that I’m not an insurance company. It didn’t matter to you that I never set aside any capital to pay you in the event that the instruments I was insuring you against actually did default. It’s a game – a trading game. Get it?

Unfortunately for the worldwide financial markets, I’m not the only one to play this game. Real insurance companies, investment banks, hedge funds, banks and lots of others have played this game. And, there’s a caveat. A big one.

All the bilateral contracts have a provision for margin to be posted; that is, collateral must be posted by me, or by American International Group Inc. (AIG), if they wrote these virtual-insurance-contracts and they start to go against us … which means that those instruments we insured actually might go into default.

AIG was bailed out to the tune of $80 billion, because it had margin calls on CDS contracts it wrote. Do you know why they now need an additional $38 billion in help? Because they are experiencing more margin calls on their credit default swaps. The Treasury and Fed never understood these instruments, let them run wild and now we are all paying the price.

That’s the story, but – as always – there’s also the story behind the story.

The leverage that was employed when CMBS and CDS contracts were bought and sold is not even known. How much did banks, investment banks, insurance companies, hedge funds and traders borrow to initiate their trades?  There are no accurate figures and not even any accurate estimates.

Now we come to the psychology of the market. No one – save my new idol, hedge-fund-manager extraordinaire and mega-billionaire John A. Paulson (who deserves every penny he made) – understood what “the crowd” was thinking. What they were thinking was that housing prices aren’t going to fall, companies aren’t going to default, and everything is under control because we’ve all calculated our Value at Risk and go merrily skipping along.

We’re not going to be okay because the plans that Treasury and the Fed have put forth weren’t plans to begin with. They are reacting, moment-by-moment to the markets.

With all due respect to Interim Assistant Secretary for Financial Stability, Neel Kashkari, he’s a “rocket scientist” and not a trader. And it was the rocket scientists who devised these securities for traders in the first place and neither group ever understood the instability and combustibility of the solid rocket fuel they were mixing. How is it possible for the talented Kashkari to gauge the markets and traders worldwide, when he’s never traded anything?

The global contagion is the direct result of margin calls that seeminglycrosses every security type (especially credit-default-swap positions), in very market, and seemingly in every country.

And the worst of it? As companies’ stock prices fall, as the value of their bonds fall and their debts mount, as they get closer and closer to actual default, the sellers of credit default swaps are getting bigger and bigger margin calls. Everyone is selling whatever they have to meet margin calls. It’s a worldwide de-leveraging – to an extent that we’ve never before conceived.

The Only Real ‘Exit Strategy’

Enough bad news. There is a way out: Shut down the CDS market. Net out all existing positions. Cancel contracts. Let CMBS holders keep their positions. And here’s why: There’s not enough money in the Treasury plan to buy them all up. Adjust the cost accounting basis on the books of holders so that they don’t have to mark those securities down. Give the Fed and Treasury unlimited transparency into every financial firm’s books on a strictly private basis and let them manage, merge and close down the insolvent “basket cases,” while guaranteeing every depositor in every bank and money-market fund.

And there’s more. Provide incentives for depositors and investors to stay with salvageable institutions by eliminating any capital gains on net new investments into these government-backstopped institutions.

Who are we kidding? Fannie Mae (FNM) and Freddie Mac (FRE) insure most of the troubled mortgages already. And that means the government. So allow all mortgages – after a certain date – to be refinanced by healthy banks whose cost of funds to make new loans should come directly from the Treasury at the Federal Funds rate. This will allow banks that write new loans to make them cheap and still have good profit margins. Make those homeowners pay back the favor by sharing the appreciation on those homes with the taxpayers who bailed them out, when they sell them.

Also absolutely necessary: Make key cuts. Cut taxes. And cut all wasteful government spending on all earmarked and pork barrel projects.

And last, but not least, put all the lobbyists in jail – especially the former legislators and their staffs who sold the American people short just to feed their own disgusting greed and avarice.

News and Related Story Links:

• Wikipedia:
  Federal Funds Rate.
• Money Morning Market Analysis:
  By Relaxing “Mark-to-Market” Rules, Has the U.S. Switched Off its Financial Crisis Early Warning System?
• AllExperts.com:
  Using Banks and Bank Accounts; Cost of Funds.
• Wikipedia:
  Mortgage-Backed Securities.
• Wikipedia:
  Commercial Paper.
• Reuters Financial Terms Glossary:
  Matched Book.
• Wikipedia:�
  Discount Window
• Wikipedia:
  Term Auction Facility.
• Wikipedia:
  Federal Deposit Insurance Corp.
• Money Morning News:
  Federal Reserve to Buy Commercial Paper to Free Up Frozen Market.
• Wikipedia:
  Federal Open Market Committee.
• McClatchy Newspapers:
  Fed’s half-point rate cut proves no match for Wall Street’s fear.
• Wikipedia:
  Mortgage-Backed Securities.
• Wikipedia:
  Credit Default Swaps.
• Wikipedia:
  Bilateral Contracts.
• Wikipedia:
  John A. Paulson.

Back to Archive

While it’s clear from the current credit crisis that our financial system is at a critical juncture, it’s just as clear that there’s no agreement over how we should fix the problems we face. The reality is that neither the plan put forth by U.S. Treasury Secretary Henry M. “Hank” Paulson Jr. – nor any of the addendums offered up by Congress or the lobbyists – will resolve this crisis.

The key culprits are the structured financial products that reside on the balance sheets of banks, dead investment banks, insurance companies, hedge funds and all manner of other duped and unsuspecting investor entities worldwide, as well as the proliferation of the unregulated $62 trillion credit default swaps (CDS) market.

Because all these securities, and in the case of credit default swaps, bilateral contracts, are impossible to value and impossible to guarantee, no one trusts them. As a result, everyone is afraid of these securities and contracts.

Banks are currently not lending to one another because they are afraid that the next round of write-downs and losses may imperil some of their trading partner banks to which they formerly lent billions and billions of dollars to every night. If the answer were really as simple as adding liquidity, the Federal Reserve would have lowered the Fed Funds target. But that won’t work. It’s a vicious cycle that’s eroding banks’ faith in one another, and worse, our faith in our banks.

Unfortunately, I don’t see the Treasury Department’s much-needed rescue plan being effective without actually addressing the pricing of – indeed, the very existence of – credit default swaps and collateralized debt obligations. As well intentioned as it is, the Treasury plan will create more problems than it solves and will eventually saddle taxpayers with so much debt that it will tank the dollar. It could even put the U.S. government’s AAA investment rating at risk. That would be calamitous.

I have a modest proposal that I’m calling the Money Morning Plan, because it potentially heralds a new dawn in the credit crisis, addressing the problems from the bottom up, and not from the top down. The bottom line is that my plan will end the credit crisis quickly with potentially little or no cost to taxpayers. And those are the two most important benefits of all. I present my plan as an open letter for public debate.

Contributing Editor and credit expert Shah Gilani outlines a bailout plan that could ease the banking crisis at a minimum cost for U.S. taxpayers. It’s a complicated issue, no doubt. Please take a look at the “Money Morning Plan” below. If you believe some (or all) of these points make sense, we urge to pass them along to your state’s representatives, as the Congressional dialogue is now in full force and time is of the essence. Just
click here to get a listing of your state’s representatives.

An open letter to U.S. Treasury Secretary Henry M. Paulson, Federal Reserve Chairman Ben S. Bernanke, Distinguished Members of Congress, and the American Taxpayers:

Dear Ladies and Gentlemen,

How we respond to the upheavals in our financial markets will define the American character at home and in the eyes of the world. With our cherished history of free markets and entrepreneurial spirit, we should guide ourselves as we always have, trusting our collective financial interests to our Constitution, which created a government by the people, for the people. Trying times are not a mandate to foreswear our personal, financial nor collective economic interests to any lobby or government other than one that protects all our rights, especially the right to not be taxed unfairly or unjustly.

The proposed Treasury Department rescue plan before Congress has not been presented without due consideration. There are, however, other proposals that merit our collective contemplation. As a taxpayer and investor, I am proposing an alternative plan for open discussion. We need to act quickly, but we need to act responsibly.

Respectfully;

Shah Gilani
Contributing Editor
Money Morning

www.moneymorning.com

The Money Morning Plan

1. Establish an empowered, not overpowering, regulatory apparatus to rein-in structured products and establish protocols for the creation and tradability of financial products based on real-world economics and hedging considerations. Products must be transparent, easily valued and rated on a universal ratings model.
2. Establish regulated standards to support the universal ratings model and allow free-market competition for providing rating services based on a “pooled-income revenue model,” whereby all issuers that either want to be rated, or that are required to be rated, pool funds on a per-volume, pro-rata basis and ratings providers are paid blindly for rating services.
3. Immediately stop the issuance of credit default swaps without mandatory reserve requirements and safeguards typical of what insurance regulations already require of legitimate insurers. Net out all existing credit default swaps to tighten counterparty risk and unwind positions that cannot be secured by issuers meeting adequate reserve requirements. Eliminate virtual insurers.
4. Only allow issuance of credit default swaps up to the actual outstanding dollar value of corporate debts and loans outstanding. This will ensure legitimate hedging and eliminate undue pressure on outstanding debt issuers.
5. Create a class of “eligible (mortgage-related only) securities” that constitutes problem securities. Leave all eligible securities on the books of existing holders.
6. Have eligible security holders identify to the U.S. Federal Reserve every eligible security by CUSIP and face amount. Only the Fed will have knowledge of institutional and investor positions. This will allow the Fed to correctly assess the risks at hedge funds and others with “significant operations” without exposing their positions to competitors.
7. Create a new accounting domain in-between “held-to-maturity” and “available-to-trade” where only eligible securities, as of a predetermined valuation date, can be accounted for at their value on the predetermined valuation date and not further subject to fair-value (marked-to-market) accounting, while held.
8. Mandate all holders of eligible securities mark-to-market inventories on a predetermined valuation date, preferably as soon as the Fed expects all eligible securities to be registered with it. Those who have recently marked their securities have already taken their write-downs; those who haven’t will have to. If the totality of the resolution represents a bona-fide solution, investors and speculators will bid up eligible securities to own them before the predetermined valuation date, because of newly ascribed accounting advantages of holding eligible securities.
9. Reduce the haircut on the reserve requirements for all eligible securities covered by this plan. Since valuations have already fallen precipitously, reducing reserve requirements on eligible securities would additionally enhance their value as balance-sheet assets with upside potential.
10. Have both the Fed and Treasury determine a liquidation or receivership outcome for holders suffering from insolvency as a result of accurately marking-to-market their holdings on the predetermined valuation date in the event bankruptcy would result in further systemic problems. This scenario would be cheaper and quicker to manage than what’s in store for us under the present Treasury draft, and it allows the two to assess the potential fallout of insolvent entities prior to their exposing the financial system to resulting disruptions. Hedge funds would not be saved.
11. The Fed must establish and manage a conservative, transparent pricing model for eligible securities based on actual underlying cash-flow measures, projections and model specific criteria. Absolutely no trading would be allowed over-the-counter or otherwise on any of the eligible-securities specific pricing models or indexes.
12. The Fed, with a firm handle on all eligible securities and a transparent-pricing methodology, would have to take in any and all eligible securities as collateral against Fed borrowings from the discount window or through its dealer facility.
13. “Servicers” managing underlying mortgages on behalf of trust entities, under which securitized pools are created, must be empowered to alter and modify terms and conditions of underlying mortgages in conjunction with originating banks or lending institutions.
14. To incentivize banks and lending institutions to modify existing mortgages and to incentivize homeowners to stay in homes with upside-down mortgage-to-appraised values, eliminate all capital gains on appreciation of newly appraised homes when they are sold by either homeowners, banks or lending institutions.
15. Create tax-advantaged scenarios for banks and homeowners partnering in the reduction of delinquent obligations whenever loans can be brought to a performing status.

News and Related Story Links:

• Wikipedia:
  Henry M. “Hank” Paulson Jr.
• Wikipedia:
  Credit Default Swaps.
• Investopedia:
  Credit Derivatives (Bilateral Contracts).
• Wikipedia:
  Structured Financial Product.
• Wikipedia:
  Haircut.
• Money Morning Market Commentary:
  Dear Ben: To Save the U.S. Economy, Here Are the Moves You Need to Make Now.
• Wikipedia:
  Securitization.
• Wikipedia:
  Asset-backed security.
• Money Morning Market Analysis Series:
  Inside Wall Street: Why Hocus-Pocus Accounting Will Perpetuate the Capital Markets Credit Crisis (Part I).
• Money Morning Market Analysis Series:
  Inside Wall Street: The Hocus-Pocus Accounting Tricks That Will Perpetuate the Capital Markets Credit Crisis.
• Wikipedia:
  Subprime Lending.
• ISO.com:
  Virtual Insurers Will Thrive in a Wired World, Says Futurist at ISO’s AISG INSTECH98 Conference.
• Wikipedia:
  Structured Finance.
• Wikipedia:
  Collateralized Debt Obligations.
• Money Morning Market Analysis:
  Why Mark-to-Market is Bad News for Shareholders.
• Wikipedia:
  Tranches.
• Wikipedia:
  Counterparty.
• Money Morning News Analysis:
  The Government’s Financial Crisis Fix-it Plan Sends Stocks Soaring, Though Some Argue There’s no Quick Fix for this Disaster.
• Wikipedia:
  Hi-Yield Debt (Junk Bond).
• Wikipedia:
  Mark to Market.
• Chest of Books:
  Eligible Security.
• Wikipedia:
  Mortgage-Backed Securities
• Money Morning Market Commentary:
  Sen. Dirksen: Allow Me to Introduce You to Standard & Poor’s.

Back to Archive

There’s nothing fundamentally wrong with the core insurance business units of American International Group Inc. (AIG). Nothing at all. What imploded the venerable insurance giant was an accumulation of misplaced bets on credit default swaps.

By the best estimates of the International Swaps and Derivatives Association and the Bank for International Settlements (BIS), often referred to as the central banks’ central bank, the notional value of credit default swaps out in the market place is some $62 trillion, or 35 trillion British Pounds at an exchange rate of $1.78.

A credit default swap (CDS) is akin to an insurance policy. It’s a financial derivative that a debt holder can use to hedge against the default by a debtor corporation of sovereign. But a CDS can also be used to speculate.

A subsidiary of AIG wrote insurance in the form of credit default swaps, meaning it offered buyers insurance protection against losses on debts and loans of borrowers, to the tune of $447 billion. But the mix was toxic. They also sold insurance on esoteric asset-backed security pools – securities like collateralized debt obligations (CDOs), pools of subprime mortgages, pools of Alt-A mortgages, prime mortgage pools and collateralized loan obligations. The subsidiary collected a lot of premium income and its earnings were robust.

When the housing market collapsed, imploding home prices resulted in precipitously rising foreclosures. The mortgage pools AIG insured began to fall in value. Additionally, the credit crisis began to take its toll on leveraged loans and it saw mounting losses on the loan pools it had insured. In 2007, the company was starting to feel serious heat.

From its humble beginnings in China in 1919 – through the 40-year tenure of CEO Maurice R. “Hank” Greenberg, which ended ignominiously for Greenberg in 2006 – AIG grew aggressively. Greenberg grew and diversified the insurance giant, ultimately amassing a trillion-dollar balance sheet.

But not everything was Kosher.

In an effort to assuage analysts and maintain leverage, the firm entered into sham transactions to affect the appearance on its balance sheet of $500 million of loan-loss reserves, which analysts had been questioning as formerly declining. The result was a 2006 Securities and Exchange Commission enforcement action, a $1.6 billion settlement and the removal of Greenberg. Greenberg is still fighting civil charges related to his actions at the firm.

As 2007 progressed, so did the losses on AIG’s books and credit default swaps. Once again, it appears that AIG tried to “manage” the problem through accounting maneuvers. Last February, for instance, AIG said that “its auditor had found a material weakness in its accounting.” It had not been properly valuing its CDO liabilities and swap-related write-downs. The losses were revealed to be in excess of $20 billion through this year’s first quarter. The SEC is once again investigating, as are criminal prosecutors at the U.S. Justice Department and the U.S. Attorney’s Office in Brooklyn.

After writing down assets against gains elsewhere, AIG posted cumulative losses of $18 billion over the last three quarters. In February, AIG posted $5.3 billion in collateral against credit default swap contracts it had written. In April, AIG had to post an additional $4.4 billion in collateral. When rating agencies Standard & Poor’s, Moody’s Investors Service (MCO) and Fitch Ratings Inc., lowered the firm’s ratings last Monday evening, it triggered an additional $14 billion collateral call as margin against AIG’s credit default swaps.

The company didn’t have the cash.

Indeed, the dire need for cash collateral on top of mounting losses on warehoused CDO “assets” on the company’s balance sheet necessitated a massive infusion of capital. That’s what happened to AIG.

But once again, there’s the story – and there’s the story behind the story.

There’s a problem – an inherently systemic problem – and it has to do with how structured investments like tranched collateralized debt obligations (CDOs), residential mortgage-backed securities (RMBS), commercial mortgage-backed securities (CMBS), and credit default swaps on them and on corporate debts and loans are actually valued.

Individually, CDOs are hard to value. Suffice it to say, legend has it that constructing the cash flow payments on the first theoretical 3-tranche CDO (the simplest type of CDO) took a Cray Inc. (CRAY) supercomputer 48 hours. Now try and value credit default swaps on them!

Because there are so many different individual CDO securities, and because there are so many credit default swaps on so many of these CDOs, and so many swaps on individually referenced entity debts and loans, the only way to value them in a portfolio is by indexing.

That’s right, there are indexes, and guess what? You can trade the indexes! Markit Group Ltd., of London, constructs and manages the CDX, ABX, CMBX and LCDX family of credit-default-swap indexes. Investopedia has a decent little tutorial.

Here’s the problem: If you own a portfolio of CDOs, and the only way to value them (or, at least, to develop a valuation that others are reasonably certain to respect), is by looking at them through the prism of an index of credit default swaps on them, you’re at the mercy of the index. Your portfolio, your securities may not be so bad, but you may not really know based on mortgage-duration analysis and foreclosure events that you can’t calculate. So you value, or mark-to-market, against the closest index.

Here’s the rub. What if other speculators are selling short – that is, betting in anticipation of that index going down? What if large portfolio-hedgers are selling short the index to hedge the portfolio they can’t sell because no one will buy it – because no one knows what it’s worth?

It’s crazy. And it gets worse.

What if you’re running a profitable company that needs to borrow money, but credit default swaps (bets against your ability to pay back your debt) are expensive by virtue of speculators fear and greed, such that if any bank looks at where the CDS pricing on your paper is trading, they tell you: “Sorry, but we can’t lend you money because the market for credit default swaps thinks you’re a bad bet.”

You don’t get the loan. You can’t build your factory; you can’t produce and have nothing to sell. The upshot: Now you actually are going out of business. Is this self-fulfilling?

Ponder this: Last Monday, as AIG was initially seeking $20 billion in capital and actually had it in hand (by virtue of a deal with New York insurance regulators), traders were bidding up credit default swaps on AIG’s debt and loans so furiously that based on the insurance premiums traders were actually paying for default insurance on AIG… the company was already dead. Self-fulfilling?

Credit default swaps are creating a downward spiral in the capital markets, driving up the cost of capital, and squeezing out all manner of borrowers. And these speculative bets run amok are undermining all U.S. Federal Reserve and U.S. Treasury Department efforts to “liquefy” the system. If this keeps up, the credit default market could sink the U.S. economy into a recession/depression that will make the Great Depression look like a day at the beach.

Anyone got a towel?

News and Related Story Links:

• BIS.org:
  Bank for International Settlements.
• Wikipedia:
  Credit Default Swaps (CDS).
• Money Morning News:
  JPMorgan Raises Bear Stearns Bid.
• Wikipedia:
  Over-the-Counter.
• Money Morning News Analysis:
  Fed Steps in and Bails Out AIG to the Tune of $85 Billion in Taxpayer Funds.
• Wikipedia:
  Mortgage-Backed Securities.
• Web Site:
  International Swaps and Derivatives Association.
• SEC Press Release:
  SEC Charges AIG with Securities Fraud.
• Wikipedia:
  Maurice R. “Hank” Greenberg.
• Money Morning Market Analysis:
  Credit Default Swaps: A $50 Trillion Problem.
• Wikipedia:
  Subprime Lending.
• Money Morning Market Analysis:
  Foreign Bondholders – and not the U.S. Mortgage Market – Drove the Fannie/Freddie Bailout.
• Wikipedia:
  London Interbank Offered Rate (LIBOR).
• Wikipedia:
  Collateralized Debt Obligations.
• Wikipedia:
  Alt-A mortgages.
• The Business Spectator:
  Rio Tinto to Sell 3-Tranche Dollar Bonds: Source.

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