My unpublished (100,000 word) book “The Financial Jigsaw”, is being serialised here weekly in 100 Issues by Peter J Underwood, author
In the last Issue we covered how some derivatives work and mentioned the ‘Interest Rate Swap’ but I didn’t go into detail about these most prevalent of derivatives. Here is a short brief and video about these potentially toxic instruments and why now, in an era of rising interest rates, many investors might get burned again:
https://www.investopedia.com/video/play/interest-rate-swap/
Here is the link to last week: Issue 42
This week we examine a derivative which confounds all logic especially as related to the fundamental essence of insurance contracts. This is the famed ‘Credit Default Swap’, (CDS) yet another obscure label for a financial instrument which is simplicity itself. Here is a brief description of this most toxic of all derivatives:
https://www.investopedia.com/terms/c/creditdefaultswap.as
What the above definition does not describe is the key to understanding a CDS and how they work. It is not unknown for owners of CDS on corporate bonds to engineer a default in order to profit from its failure.
https://www.zerohedge.com/news/2019-03-05/after-irreparable-damage-warnings-wall-street-finally-cracks-down-cds-manipulation There is no end to the financial manipulations of these Wall Street criminals!
By the way, it was key people during the run up to the 2008 crisis that made fantastic profits out of CDS, because they were some of the few that foresaw the coming crisis; some are now billionaires and all credit to them (forgive the pun!). People like:
https://www.investopedia.com/financial-edge/0411/5-investors-that-are-both-rich-and-smart.aspx and also it might be worth reminding ourselves briefly of what happened as it is likely to happen again soon:
https://www.forbes.com/2008/12/31/housing-bubble-crash-oped-cx_bb_0102bartlett.html#1ac220a55a43
Just so you know: here is a sample of 25 people who were at the heart of the crisis and who didn’t go to jail, and what they were doing in 2012 – five years after the crisis:
https://www.theguardian.com/business/2012/aug/06/financial-crisis-25-people-heart-meltdown
CHAPTER 8
Financial Engineering
“Something hit me very hard once, thinking about what one little man could do. Think of the Queen Mary — the whole ship goes by and then comes the rudder. And there’s a tiny thing at the edge of the rudder called a trim-tab. It’s a miniature rudder. Just moving the little trim-tab builds a low pressure that pulls the rudder around; takes almost no effort at all”.
Richard Buckminster Fuller
A real example of how a standard insurance contract works
When I was younger I was naive enough to be unaware of the underlying rules of insurance. I figured out that the last time a house in my area became a total loss due to fire was some centuries ago so I was paying for fire insurance which I really didn’t need if I was prepared to take a small risk.
However to guard against even this small risk I thought that by approaching the neighbours we could combine all our small risks and take out just one policy (at far less cost than each individual policy) covering all our houses against fire which remained a very tiny risk because the risk of all the village burning down is no greater than just one house. This is sort of the obverse of the bankers’ mortgage backed securities scam which we covered last week. Guess what?
The insurance company advised me that this was not possible because “I did not have an insurable interest in all the houses”. This is a fundamental rule of insurance in general which prevents people taking out policies on things they do not own or in which they have no interest, that is, an insurable interest. It is sensible that insurers will not allow more than one policy on any item otherwise many people could insure your house against fire and make a huge profit by setting it on fire!
Credit Default Swaps do not follow the same rules as insurance contracts
Not surprisingly the bankers have thought about this problem but have ignored it in the case of CDS. Anyone can take out a CDS contract against default of any loan at a given premium so that if default occurs many claims can be made against the insuring party.
I know this sounds so simple as to not be possible but it is exactly what brought down The American International Group (AIG) in 2008, as part of the MBS meltdown. This massive insurance company was brought to its knees because of the many CDS contracts it had written on loans issued against defaulting mortgages and not having sufficient reserves to back these contracts. Perhaps we should not offer these megalomaniacs the imposing title of “Masters of the Financial Universe” after all.
Bending the accounting rules to hide balance sheet liabilities
The current (distorted) accounting rules in the United States go so far as to allow banks to hide debt obligations that are classified as ‘derivatives’. They do this by off-setting their derivative valuations, which are currently profitable, against valuations that have losses and show only the net value in their accounts.
This has several effects by not only artificially reducing the total gross value of their declared ‘assets’ on their balance sheet (i.e. loan obligations in the case of banks) but also obscures the risk of the bank itself defaulting by understating its leverage or gearing ratio.
As a reminder, in Chapter 1 we discussed the key measure of a bank’s health by looking at the difference between its ‘assets’ (loans given out) and its ‘liabilities’ (depositors’, shareholders’ and bondholders’ money); this being expressed as a ratio which should be in the range 1:12-15 but which most banks today are much more, rather in the 1:25-35 range even allowing for misrepresentation of their derivative positions and other accounting skulduggery.
As you may by now realise the banks have done an excellent job of persuading the Financial Accounting Standards Board (FASB), the accounting standards regulator which sets the rules, to look the other way when examining the banks’ published accounts. The reason for this is that the ‘Too Big To Fail’ mentality has swept the regulatory industry causing them to be ‘captured’ by the big banks as well as being hand-in-glove with government and politicians in order to avoid what is likely to be yet another crisis in the future.
The FASB even proposed new accounting standards for insurance that would force many contracts not called ‘insurance’, being basically the same thing, to be accounted for in the same way as insurance contracts. However CDS were exempted from this rule and one does not have to look too far to know why.
Banks and financial institutions are protected by regulators and tax payers
The massive derivatives markets are so varied and extensive that many books have been written on the subject and I have found many of them readily understandable and readable even if the subject is of a specialist nature.
For those interested in further reading, the book: “Too Big To Fail” by Andrew Ross Sorkin describes in detail the inside story of how ‘Wall Street’ duped a generation of investors. It is always the investors that suffer losses when these securities fail, never the banks and financial institutions who manufacture them, because they are underwritten by the taxpayer through government; from which arises the well-known adage: “Privatising the profits, socialising the losses”.
Government, regulators and central banks will have a hard time reining in the excesses of these bankers and financial wiz-kids although they will have to regulate them at some point or another if a future crisis is to be addressed.
The Bank of England faces similar risks associated with the bankers’ dealings
The Governor of the Bank of England, Mr Carney, faces a formidable set of challenges. The size of Britain’s largest banks amount to 400% of the total UK economy and their culture has not changed much since the last meltdown in 2008 even though there have been several high profile cases in the intervening period.
The UK Chancellor has indicated that he regards the BoE’s task as ‘stabilising the economy’ and Mr Carney will be blamed if a there is little or no recovery. The link between government’s management of money and the BoE’s *‘financial stability function’ is unprecedented:
*Financial stability function:
A supposedly well-capitalised bank in the UK or EU can have 97 pence of debt per £1 of assets (i.e. just three pence of equity!). Such a low loss-carrying capacity of 3% would be severely penalised in the USA, where regulators are asking 6%, some responsible officials in USA are asking for 10% or higher whilst the banks’ ‘Non-performing Loans’ (NLP) are increasing all the time, especially in Europe, placing the ‘solvency’ of all banks under increasing strain and at risk of bankruptcy.
Banks all over the world are carrying the heavy burden of ‘toxic’ debt, mainly in the form of derivatives, leaving them highly vulnerable to any rise in interest rates as happened briefly in the summer of 2013. I cannot emphasise more that the global economy and taxpayers everywhere remain seriously at risk of losing their savings in the next crisis which is one of the main reasons I chose to write this book; to warn of the risks whilst garnering an understanding of why these risks are present.
To be continued next Saturday
Could Congress pass a law declaring all CDSs must meet the same condition or principle as property insurance and any that don’t are void and their premiums returned. If the crash comes first, Congress declare them all void.
Wouldn’t that be good Robert, but the captured lawmakers are never going to go against the vampire squid. CDS are made this way so the pigs can slop at the trough – you need megabucks to play the game.
I predict When savers/depositors lose their savings the lives of many bankers shall be lost as well.
You are so right, WASd, and there will much gnashing of teeth and hanging them high. I don’t think the banksters and bureaucrats have understood how caustic the bail-in laws are. When the general public wake up there is certainly going to be very disappointed people about – to say the least!