Tick, tick, tick

October 4, 2011

There are clusters of undetected time bombs ticking away in the financial system. And if it explodes, it will magnify the chaos caused by any defaults in the Eurozone, pushing the world economy into a deep, deep chasm.

The ordinance that gives these time bombs their potency are little known derivatives called credit default swaps (CDS). These privately negotiated contracts between two parties in which one party insures against a company or, in this case country defaulting on its debts. For a relatively small premium, the counterparty (namely the insurer) agrees to pay out a certain amount in those circumstances.

Such insurance policies make sense if, say, you do business in Greece, Portugal, Italy or any one of the countries tottering on the edge of bankruptcy, thus facing the real possibility that they could default on what they owe you.

The problem is that speculators have been taking out CDS contracts in the hope that one of these European countries will go belly-up. Therefore, they are no better than vultures eager to feast on road kill.

To gain insight on the dangers these time bombs pose, there are currently around $45 trillion in CDS contract in play at the moment – three times the world GDP. This explains why investor Warren Buffett called CDSs the “financial weapons of mass destruction.” The very size of this market proves that most of those involved are speculators, who believe it an easy way to make money.

In determining the trigger in which a CDS will be paid out, contracts usually refer to a “credit event.” While Greek bondholders have taken a haircut, this has not yet been declared an official credit event because it is viewed as “voluntary”. And so, no CDS contracts have been paid out.

Who, then, decides when a country officially defaults such that it is accepted as a “credit event” and a massive CDS payout? The trigger lies in the hands of a little-known organization called the International Swaps and Derivatives Association headquartered in New York. Here we have an example of self-regulation.

Over the years the ISDA has successfully defended its right to self-regulate the over-the-counter derivatives market. Even after the last global financial crisis, when derivatives were a major contributing factor, the ISDA continued to successfully resist reform. Thus, the decision of when a “credit event” occurs remains in the hands of the faceless ISDA men and women who run the ISDA. It is they who will decided whether or not the world is plunged into another crisis.

The truly scary aspect of derivative trades is that it is all done over-the-counter in private contracts and because they are not traded in public exchanges, no one really knows who holds CDSs and could be open to large payouts.

We have no better example than AIG in 2008. AIG got a nasty surprise when it discovered that it held the wrong side of a large number of CDS contracts. So when the sub-prime market went belly up, AIG had to pay out hundreds of billions of dollars to Goldman Sachs, Société Générale SA, Deutsche Bank AG and other firms when they came knocking on its door to collect.

Therefore, when one of the countries in the Eurozone defaults (as decided by the ISDA), then a new freeze will take over the credit market. Since no one really knows which banks could be liable for enormous payouts under their CDS obligations, and therefore could go broke, trading will stop until the smoke clears and the market pinpoints those unsustainably exposed to CDS liabilities.

Here we have an example of how far the global financial system has been privatized. We also see how dangerous ISDA’s self-regulation system is. Its lack of transparency threatens to push the world’s economy over the edge once more.

 

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