September 25, 2008

CREDIT DEFAULT SWAPS - THE INSANE PROBLEM AND THE RADICAL BUT SANE SOLUTION

By Chuck Simpson

The paramount reason for today's cancerous  credit crisis is seldom even hinted and never explained.

First, a simple definition. A credit default swap is a form of insurance. A variant of mortgage insurance required of many home purchasers. An insurance policy that requires a company with financial strength to step up to the plate and pay the mortgage if for some reason the home buyer defaults.

A credit default swap is similar: If default occurs, an insurance company pays the income stream of the mortgage.

With one extremely important difference: Payments are made to the owner of the policy, not to the financial institution that stands to suffer a loss.

Financial institutions are allowed, through total lack of regulation, to buy and sell credit default swaps, or insurance they will be paid in event of default, on financial instruments in which they have no financial interest.

Start with a simple example. Assume I know the young son of the couple next door likes to crawl into closets and play with matches. I therefore see a reasonably good shot at "winning the disaster lottery" so to speak, by buying fire insurance on their $200,000 house.

In simple terms, I now have a financial interest is seeing that disaster occurs. If the house, for whatever mysterious reason, burns down an insurance company will pay me the insured value of the house - even though I suffered no loss, financial or otherwise. My neighbor's misfortune is thus magically transformed into my good fortune. A polite way of saying I was paid $200,000, the insured value of my next-door neighbor's house, after I paid the $400 insurance premium.

Being bright and suitably equipped with an MBA from a prestigious eastern university, I well and fully understand the desirable objective of maximizing my return on investment. I can accomplish this in one or both of two ways - increasing the return or decreasing the investment.

I can increase the return by artificially increasing the value of the house - say from $200,000 to $400,000. This will allow me to collect twice as much for suffering no personal loss. The easiest way to accomplish this would be to hire one of my buddies, who happens to be a real estate appraiser, to "document" the higher value.

I could also decrease my investment - meaning the premium I paid for the insurance, say from $400 to $200. The easiest way to do this would be to hire a widely acclaimed "fire risk rating agency" to send out an inspector who will look around (or perhaps only drive by without stopping) and then solemnly declare: "This house is fireproof".

Poors and Standard Fire Rating Company and Doomys Fire Rating Agency would be excellent choices, based on their prior experience.

In the real world, meaning Main Street as opposed to Wall Street, this would be illegal. Against the public interest, because it encourages houses to mysteriously burn down. The insurance policies owned by people without a financial stake in the fire would be declared null and void because they are contrary to public policy, which sees minimizing the number of mysterious house fires as a good thing.

Rather than a bad thing, as now occurs under America's predatory capitalist system.

Now change an assumption. Assume I tell 99 of my poker-playing gambler friends about the boy's strange and dangerous interest. Starting with my appraiser buddy, who's predatory income as a result of a mysterious fire will double, as a direct result of his appraisal.

Now assume the $400,000 house burns to the ground. One hundred or so insurance companies will collectively pay $40 million in claims on the loss of a single $400,000 house. The benefits of a $400,000 disaster are magically multiplied by a factor of 100 and transformed into a $40 million disaster - with one family suffering a loss and 100 families experiencing a gain. The losses of the insurance companies don't count, because, in America's capitalist society, they are in the business of writing insurance - and paying claims for losses.

But in today's society, fire is not the only disaster that can be insured against. Of particular interest, default on a home mortgage can be insured against. And possession of an interest in the mortgage or actual risk of financial loss as a result of default is not required in order to purchase the insurance.

In this case also, I can increase my return with an inflated appraisal and decrease my investment by declaring the risk to be minuscule - meaning rated AAA by widely acclaimed rating agencies.

We can now change another assumption. Assume the playing with matches problem is removed and a new problem is substituted. A problem like the husband and wife both having low-paying jobs and no health insurance, coupled with knowledge that many employers refuse to accept illness as a legitimate reason for missing work and have iron-clad policies that require ill workers be fired for failing to report to work.

Or assume both husband and wife have no seniority and work at jobs that may not exist tomorrow because they were shipped overseas last night.

If I knew one or both of them were developing health problems or that one or both were at risk of being laid off, I would see a reasonably good shot at "winning the disaster lottery" so to speak, by buying mortgage default insurance, also known as a credit default swap, on their $400,000 house.

Then I could sit back, relax and wait for the hoped-for and expected misfortune, which will be my good fortune. As could 99 of my gambling buddies.

Back to the neighbor's home that mysteriously burned to the ground. This tragic event is a great deal for me and my 99 gambling buddies. Our biggest risk is that, having paid the insurance premiums, the home stubbornly refuses to burn to the ground.

Being capitalists, we desire to increase the odds that a disastrous fire will occur. My friends and I with fire insurance policies on my neighbor's house have two options for increasing the odds. One, teach the young child the joys and wonders of paying with matches in closets. Two, hire a professional arsonist.

Holders of credit default swaps have similar but more numerous and less risky opportunities to increase their odds of "winning the disaster lottery".

The best way would be use of fine-print, non-understandable escalator clauses that increase the hard-working couple's monthly payments by a factor of two or three. With rampant inflation, confined to core goods that officially "don't count" in Washington, such as $4.00 gasoline, $5.00 milk and $3.00 bread. With rampant if covert support of immigrant labor, legal or otherwise, who are willing to work for less, without any benefits at all, let alone health insurance, thereby increasing the risk of job loss.

We could destroy OSHA, making on-the-job causes of illness and injury more likely. We could buy legislation that benefits pharmaceutical companies while making both medicine and health insurance unaffordable. We could destroy the economy of Main Street, making job loss more likely. The list is extensive, collectively making early default all but inevitable.

That issue addressed, our biggest worry becomes the solvency of the insurance companies. That problem can best be solved by requiring substitution of a "bigger and better" insurance company with deeper pockets.

Purchasing legislation and regulations (or the lack thereof) is the preferred method.

Roughly a quarter-century ago, when I was owner of a new and small consulting engineering firm in a Midwestern state, a law was passed requiring that operators of coal strip mines reclaim the messes they made. To ensure this might actually happen, the new law required coal mine operators to post reclamation performance bonds, payable to the state. So if the operators went bankrupt, the state could call the bonds, thereby obtaining funds for the state to hire and pay remediation contractors.

I never understood at the time why the small independent strip mine operators had so little interest in hiring a consulting engineer to design mining and reclamation operations so as to minimize reclamation expense, or even to provide honest estimates of expected reclamation expenses. Until, in an unguarded moment, one small operator explained Plan B.

At the time, only $250,000 in financial assets were required for formation of an insurance company, and once formed, no limits were placed on the value of insurance written. Same for performance bonds written to the government that granted the license and regulated.

As chance would have it, a dozen or so small mine operators joined together and kicked in about $20,000 each, thereby building a kitty of $250,000. They solicited a straw man and formed their very own little insurance company. That company specialized in writing strip mine reclamation bonds, with the state as an insured party. The amounts of the bonds were based on remediation cost estimates that were provided by the operators who paid for the bonds. This insurance company was issued a license even though the owners never at any time had any intention whatsoever of paying claims they knew would be filed.

Mining operations continued as before. Meaning horrendous messes were left behind. When the meses were discovered, ABC mining companies declared bankruptcy. Corporate assets, usually consisting only of a worn-out backhoe and a dilapidated dump truck, were liquidated for each of the companies. DEF mining companies with different well-used backhoes and dump trucks were formed to exploit the next sites.

As to ABC's sites: The state called upon the insurance company's performance bonds so the state could clean up the messes. And the state did.

Reclamation work "estimated" by the mine operators to cost about $6 million was performed, at a cost of about $70 million. All but about $250,000 was paid for by the taxpayers, after the insurance company filed bankruptcy.

Substituting A.I.G. and similar institutions for the name of the miner's small insurance company will explain much of America's current situation.

As with reclamation of strip mines, the insurance companies will file for bankruptcy. Government, via a $700 billion emergency rescue plan, will step up to the plate. The costs will be paid by taxpayers who have seen only losses and no gains. Pursuant to a rescue plan that prohibits any and all forms of congressional or judicial oversight or opportunity to object.

Except for reports, to be filed twice yearly. Something akin to the fox being required to periodically report how many chickens he stole from the hen house, without being required to return any of the stolen chickens. And who will keep this count? The fox.

The inevitable bankruptcy of A.I.G? What other option exists for a company with a market value of $12 billion and liabilities of about $450 billion on credit default swaps written to hedge funds, many of which are headquartered offshore and thus pay no taxes in the United States. For this, the government is paying $85 billion in taxpayer's money. In return, the government, meaning the taxpayers, will be entitled to receive 80 percent of the company's stock. Stock that is all but assured to be totally worthless.

For insurance company executives, financial risks of corporate bankruptcy are all but non-existent. Lehman Brothers is a prime example. On September 15, Lehman filed bankruptcy - the biggest in America's history. Hours before, the New York headquarters was scrambling for cash. Other banks were refusing to provide loans to Lehman. Banks with loans outstanding were demanding immediate repayment. Counter parties to Lehman's credit default swaps were selling out at ten cents on the dollar.

Lehman's response: Hours before the bankruptcy filing, Lehman transferred $2.5 billion from the London office to the American holding company. This money had "accrued as part of group profits from the first nine months of the year" and will be used to pay employee bonuses. As a result, the London office had no funds with which to make the payroll.

Presumably. part of that money will be used to pay a bonus to Lehman CEO Richard Fuld, Jr. Last year he made $71 million. In better times, namely 2006, he was the fifth-highest paid CEO in America. His total compensation was $122.67 million.

Working American taxpayers rightly question whether firms such as this, managed by people such as this, should be bailed out. And question if the bailout will be administered fairly.

Just cause exists for questioning. Should taxpayers be concerned (or outraged) that the fox who wrote the emergency plan and will be responsible for guarding government's $700 billion hen house is Treasury Secretary Hank Paulson?

Paulson, who amassed a fortune estimated to total $700 million during his 32-year career at Goldman Sachs, the main competitor of Lehman?

Paulson, who will be allowed to purchase worthless securities from Goldman Sachs and offshore hedge funds at prices that he alone will determine but probably not disclose, without being subject to congressional or judicial oversight of any sort?

Paulson, who refused to even consider bipartisan calls for tighter regulation or reform after sending his emergency proposal to Congress at 1:30 A. M. last Saturday?

Paulson, whose previous employer Goldman Sachs was granted a request to convert to a bank holding company with full access to the Federal Reserve's emergency loan program by his buddy Bernanke?

Paulson, who failed and sometimes refused to regulate and now claims changes to his proposal aren't possible because of an emergency that resulted from his failure or refusal to regulate?

Paulson, who last Sunday rejected suggestions that his taxpayer-funded program be revised to provide any sort of relief for homeowners facing foreclosure?

Paulson, who steadfastly refuses to consider taking a hard look at A.I.G. and other financial firms. How could these companies, managed by the so-called "best and brightest" guys in the room, have committed such a long and horrendous series of "poor judgments"?

By accident, or sheer incompetence?

Hard to believe, given that everyone in the room knew millions of explosive mortgages were being written to families without sufficient income, or in some cases no documentation of any income at all, based on fraudulent appraisals and supported by fraudulent AAA ratings.

Given the size and blatant nature of the disaster, accident and incompetence excuses simply don't fly. Something more was involved. That something is the number and size of vultures who bet on and stand to gain from the disaster, and how much they stand to gain. Too many people owning fire insurance on my neighbor's valuable house.

In my house fire insurance example, the insurance companies that wrote the polices risk going broke, due to an unprecedented number of mysterious house fires, each resulting in an unprecedented number of claims.

The proposed bailout asks for $700 billion. The number of homes through, in the process of or facing foreclosure is currently about five million. Meaning the cost will be about $140,000 per home.

But the problem as to credit default swaps is much bigger. The notional value of credit default swaps outstanding is estimated to be about $62 trillion.

This is about $12.4 million per home. About 31 times the value of a $400,000 home.

No wonder America is experiencing an emergency of mysterious financial house fires. And who will benefit? Those who taught and then encouraged the boy to play with matches.

The Sane Solution

Our leaders warn of dire consequences: If the $700 billion bailout bill is not passed immediately, without debate, let alone modification, economic growth will "suffer".

But America has already experienced years of economic growth. And suffering. The parasitic, predatory type of growth I've described has already resulted in many years of much suffering on Main Street.

More suffering? The honest, hardworking people of Main Street USA who would never dream of attempting to make a profit on someone else's disaster deserve to see much more than suffering. They deserve to see death. Of all the financial institutions that sought to get rich on the backs of hardships suffered by or intentionally inflicted on others.

This is not the type of economic growth that should be saved. This is the type of growth that should be killed in its tracks, as dead as possible, the quicker the better.

One excellent first step would be rejection of the $700 billion burden to be placed on the backs of taxpayers.

An excellent second step would be judicial declaration that the value of any and all credit default swaps is zero, as being against public policy that requires that activities than encourage mysterious fires or other forms of disaster are illegal as contrary to public policy.

Yes, you heard me right. Judicial determination that all $62 trillion worth of credit default swaps are null, void and totally worthless.

Only then can a just and humane financial system can be constructed upon the ashes of the old.

This process could and should be facilitated by all honest citizens withdrawing all their funds from all financial institutions, notably including bank checking and savings accounts and money market funds, but possibly excluding local credit unions that loan in and support the local community. I urge all American citizens to do this, as quickly as possible, to the maximum extent possible. If for no other reason, then for self-defense. All must realize no bank is safe and FDIC is one major collapse from insolvency.

The intended result: The quick death of the financial system that has sentenced all of us to a slow death.

All citizens should consider and choose: Will they be among those meekly walking to the cattle cars because of vague promises of a better life, or among those who stood up so bravely in Warsaw.

Chuck Simpson, aka azchuck

Please disseminate as widely as possible, including to all members of Congress. Preferably starting with Ron Paul.