[Marxism] Credit Default Swaps: Next Phase of an Unravelling Crisis
Dbachmozart at aol.com
Dbachmozart at aol.com
Sat Jun 7 13:59:00 MDT 2008
The Financial Tsunami has not reached its Climax
Credit Default Swaps: Next Phase of an Unravelling Crisis
By F. William Engdahl
hkOq9Rxg==) , June 5, 2008
The Sub Prime Meltdown is but the Tip of the Iceberg
While attention has been focussed on the relatively tiny US "sub-prime" home
mortgage default crisis as the center of the current financial and credit
crisis impacting the Anglo-Saxon banking world, a far larger problem is now
coming into focus. Sub-prime or high-risk Collateralized Mortgage Obligations,
CMOs as they are called, are only the tip of a colossal iceberg of dodgy
credits which are beginning to go sour. The next crisis is already beginning in
the $62 TRILLION market for Credit Default Swaps. You never heard of them? It’s
time to take a look, then.
The next phase of the unravelling crisis in the US-centered "revolution in
finance" is emerging in the market for arcane instruments known as Credit
Default Swaps or CDS. Wall Street bankers always have to have a short name for
As I pointed out in detail in my earlier exclusive series, the Financial
Tsunami, Parts I-V, the Credit Default Swap was invented a few years ago by a
young Cambridge University mathematics graduate, Blythe Masters, hired by J.P.
Morgan Chase Bank in New York. The then-fresh university graduate convinced
her bosses at Morgan Chase to develop a revolutionary new risk product, the
CDS as it soon became known.
A Credit Default Swap is a credit derivative or agreement between two
counterparties, in which one makes periodic payments to the other and gets promise
of a payoff if a third party defaults. The first party gets credit
protection, a kind of insurance, and is called the "buyer." The second party gives
credit protection and is called the "seller". The third party, the one that might
go bankrupt or default, is known as the "reference entity." CDS’s became
staggeringly popular as credit risks exploded during the last seven years in the
United States. Banks argued that with CDS they could spread risk around the
Credit default swaps resemble an insurance policy, as they can be used by
debt owners to hedge, or insure against a default on a debt. However, because
there is no requirement to actually hold any asset or suffer a loss, credit
default swaps can also be used for speculative purposes.
Warren Buffett once described derivatives bought speculatively as "financial
weapons of mass destruction." In his Berkshire Hathaway annual report to
shareholders he said "Unless derivatives contracts are collateralized or
guaranteed, their ultimate value depends on the creditworthiness of the
counterparties. In the meantime, though, before a contract is settled, the counterparties
record profits and losses -often huge in amount- in their current earnings
statements without so much as a penny changing hands. The range of derivatives
contracts is limited only by the imagination of man (or sometimes, so it
seems, madmen)." A typical CDO is for five years term.
Like many exotic financial products which are extremely complex and
profitable in times of easy credit, when markets reverse, as has been the case since
August 2007, in addition to spreading risk, credit derivatives, in this case,
also amplify risk considerably.
Now the other shoe is about to drop in the $62 trillion CDS market due to
rising junk bond defaults by US corporations as the recession deepens. That
market has long been a disaster in the making. An estimated $1,2 trillion could
be at risk of the nominal $62 trillion in CDOs outstanding, making it far
larger than the sub-prime market.
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