The Next Banking Bomb?

CBS News Investigates: Credit Derivatives Comprise $54.6 Trillion Of Risk Among Few Banks Left Standing

(CBS)  CBS News Investigative Unit’s Kim Lengle wrote this story for CBSNews.com.

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“This bill will, in my judgment, raise the likelihood of future massive taxpayer bailouts. …if you want to gamble, go to Las Vegas. If you want to trade in derivatives, God bless you.”

That was North Dakota Senator Byron Dorgan’s statement on the floor of the Senate - not this week or last, or even during the last six months as Wall Street collapsed - but back in 1999.

Four years later in a letter to shareholders, billionaire investor Warren Buffett followed with his own warning, calling derivatives “weapons of financial mass destruction” controlled by “madmen.”

While financial experts were concerned with the housing bubble and mortgage-backed securities, Dorgan and Buffett were focused on what many now believe may be the next big shoe to drop - the credit derivatives market, better known as credit default swaps.

What worries financial insiders most is the $54.6 trillion of risky credit derivatives concentrated among the few banks left standing.

Credit default swaps (CDS) are the cornerstone of the credit derivatives market accounting for more than 98 percent of all credit derivatives. They are difficult to understand, ignored by regulators and poorly reported on balance sheets. In simplest terms, CDS are insurance policies on things like bonds, loans and corporate debt. But there are two big differences: the seller of a CDS doesn’t need to have the money to cover losses if the security defaults, and the buyer doesn’t need to own the asset it wants to protect.

It’s as if hundreds of people could buy insurance policies on houses they didn’t own yet still collect the full value if it burns down.

The danger comes when the company defaults and the seller - because he’s not required to - doesn’t have the money to pay out on the default.

Investment firms that traded various derivatives, such as CDS, collected an average of $2 billion in fees each quarter over the past two years. And traders who spoke to CBS News said these transactions were the largest cash cows on Wall Street, even more profitable than mortgages. The newfangled transactions were seen as easy money and many traders had the attitude that when it blows up, it’s someone else’s problem.

Today, the same commercial banking heavyweights thought to be the most safe, JPMorgan, Citigroup Inc. and Bank of America, hold 92 percent of all the disclosed credit derivative contracts, according to the Office of the Comptroller of the Currency.

But that number is merely an estimate because the overwhelming majority of these contracts are unregulated - private, mostly undisclosed and difficult to measure.

“There is no question we are at the edge of the cliff and someone is going to fall off,” said Weil, Gotshal & Manges Senior Partner Harvey Miller who is currently overseeing the Lehman Brothers bankruptcy.

Back in 1999 when the legislation was being debated Senator Dorgan opposed the consolidation of commercial and investment banks. In fact, he sponsored two amendments to prohibit these new mega-banks from …investing in derivatives.

Today, Dorgan apparently feels the same way. He was one of 25 senators who voted no on the recent $700 billion bailout.

“No one knows where [the credit derivatives] are, whose balance sheets they may threaten, or how much additional risk they pose to financial firms. Yet, I was told this plan could not require regulation and transparency of these financial markets because there was opposition in Congress and the White House,” Dorgan said in a statement explaining why he didn’t vote for the bailout.

With banks already suffering losses from the subprime fiasco, many now believe they face chain reaction failures from the credit derivatives market.

“If the market keeps going in the direction it’s been going, you’re going to have lots of defaults which are dangerous things,” said Miller.

Some economic analysts predict even more panic over next few months. As more corporations default and banks find out they can’t make good on their contracts, a new round of losses for funds and financial firms could result and make the recent losses in mortgage-backed securities seem miniscule by comparison.

[dwalker3720]

Soremeat,

You need to check your math, your plan would not cost 200M, but 200T.

[cg37102006]

it is problematic when the so called experts dont understand the products they are selling, buying or rating. This whole thing is eerily similar to the Enron fiasco of a few years back. Remember that the biggest problem with Enron was that they were creating these exotic energy financial products that regulators and investors didnt understand, which meant that no one but Enron really knew how bad a shape their balance sheets were in. Looks like we as a nation need to curb all these ingenious inventive financial products and just stick with good old fashion savings accounts, stocks and fixed rate loans. You know, real stuff that people can understand.

[hypnotoad72]

No finagling at the top alone will restore the American economy. 75 percent of the economy is driven by the spending of ordinary consumers and they are frightened. Call it PTS and it will not be cured easily. The distribution of free booze and Prozac will jerk start spending again. That is the only quick fix that is possible.

Posted by melpol1
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And then media articles will say nobody saves anymore...

Vicious circle and nothing is addressed.

[melpol1]

No finagling at the top alone will restore the American economy. 75 percent of the economy is driven by the spending of ordinary consumers and they are frightened. Call it PTS and it will not be cured easily. The distribution of free booze and Prozac will jerk start spending again. That is the only quick fix that is possible.

[t_barr]

Millionaire bankers threaten exodus to Mumbai if denied their six-figure bonuses.
www.allnewsweb.com/page53.html

''As the world faces a possible recession and a collapse of the banking system and while millions of ordinary citizens worry about an uncertain future a cry has been heard from the City of London bankers: Don''t cut our bonuses.

The very people who apparently took wild risks with investor''s money are in fact threatening to leave London for places like Mumbai if indeed their colossal pay packets are touched.

In companies like Lloyds TBS and Barclays directors and board members pay is generally restrained as these a required to be published in annual reports distributed to shareholders. However coal-face traders can in fact earn substantially more.

Big salaries are not restricted to the upper echelons of management. Over 4000 inner city bankers earned bonuses last year over the million pound mark and even rookie traders expect high six figure bonuses. The average annual salary for a trader in the debt market is #680,000.

John Trevor-Highton, of the Goldman Sachs firm comments that ''All the talk now is of work in Mumbai or possibly China, if bankers pay is any way cut'' another city worker told us that ''What you will see is a massive brain drain that will starve the city of talent''

Many angry onlookers might be wondering what exactly does that talent consist of as news of the bonus fueled risks and the subsequent collapse of banking are publicised.''

[t_barr]

Tape Blows Cover On True Treasury Intentions
www.economicpolicyjournal.com/2008/10/tape-blows-cover-on-true-treasury.html

''The new kid at the Treasury hasn''t quite learned you really can''t talk in public about what you are really up to at Treasury. New Interim Assitant Secretary of the Office of Stability Kashkari (Cash n Carry), has been caught on tape providing the true details of what Treasury is up to. This will get him muzzled pretty fast, but it provides us the opportunity to see the scheming going on at Treasury.

Wall Street Journal reviewed the tapes and reports first on the fact that Kashkari considers the executive pay caps demanded by Congress a joke.

-The dates are important because Kashkari, also reported to the financial insiders that, ''Our preference would be to try to help healthy banks become even healthier.'' Remember, the entire focus, at the time, was on buying up bad mortgages and there was no news out publicly about Treasury helping ''healthy banks''.

-As Bob Murphy has pointed out, they haven''t even bought one mortgage yet, so how could they have failed at attempting to unlock the supposed frozen market?

-''New interest''? ''New options'' ''After yet another tumultuous day''? Then why was Kashkari talking about these details to the industry, even BEFORE the first House vote?

We have a smoking gone here, you would have to be blind not to see that the Bernanke-induced crisis is being used by Paulson to funnel money to Goldman and his other crony favorites.''

[sandinyc]

This isn''t the "next" big bomb. It is THE bomb that has already exploded. Subprime gets all the print because it is the underlying asset class that burst first.

[latrocinor-2009]

The American way of life is dead...
Posted by Hacker11001

Things change. The American Way Of Life changes too,

It''s still the American Way Of Life and it is not dead by any means, it simply evolves.

[latrocinor-2009]

And I do not need a speech on morality. Human nature is what it is, people were no less "good" or "bad" 50 years ago or 500 years ago. Unless you have some sort of "good" and "evil" statistics you would like to share with us all.

Posted by curse914

The "evil" or "morals" things come from judgments about certain behaviors that are helpful or destructive to a tribe or a large society.

The word "morals" can easily be shown to evolve from "general rules that if followed will have a high statistical chance of bringing about a robust society".

The word "evil" can easily be shown to evolve from "general behaviors that if followed will have a high statistical chance of bringing about a non-robust society".

For what it''s worth, these generalized rules have evolved over tens of thousands of years.

[Razzl]

I suppose this might be a naive question, but if the same handful of players hold virtually all of these CDS''s, and they now appear imprudent and should be cancelled, wouldn''t it be a fairly easy matter for each of them to analyze how much they would owe to the other players for what they purchased and then just do some kind of bookkeeping transaction to wipe them out? Granted a couple of them may have to pay back a little more than they get, but all the legal liability would be erased and the effect on the bottom line might be negligable to the payer when everything else is a wash...