In an article titled "Still No End to 'Too
Big to Fail'", William Greider wrote in The Nation
on February 15:
Financial market cynics have assumed
all along that Dodd-Frank did not end "too big
to fail" but instead created a charmed circle of
protected banks labeled "systemically important"
that will not be allowed to fail, no matter how
badly they behave. [1]
That may be,
but there is one bit of bad behavior that Uncle
Sam himself does not have the funds to underwrite:
the US$32 trillion market in credit default swaps
(CDS). Thirty-two trillion dollars is more than
twice the US gross domestic product and more than
twice the national debt.
CDS are a form of
derivative taken out by investors as insurance
against default.
According to the Comptroller of the Currency,
nearly 95% of the banking industry's total
exposure to derivatives contracts is held by the
nation's five largest banks: JPMorgan Chase,
Citigroup, Bank of America, HSBC, and Goldman
Sachs. The CDS market is unregulated, and there is
no requirement that the "insurer" actually have
the funds to pay up. CDS are more like bets, and a
massive loss at the casino could bring the house
down.
It could, at least, unless the
casino is rigged. Whether a "credit event" is a
"default" triggering a payout is determined by the
International Swaps and Derivatives Association
(ISDA), and it seems that the ISDA is owned by the
world's largest banks and hedge funds. That means
the house determines whether the house has to pay.
The Houses of Morgan, Goldman and the
others in the Big Five are justifiably worried
right now because an "event of default" declared
on European sovereign debt could jeopardize their
$32 trillion derivatives scheme. According to Rudy
Avizius in an article on The Market Oracle (UK) on
February 15, that explains what happened at MF
Global, and why the 50% Greek bond write-down was
not declared an event of default. [2]
If
you paid only 50% of your mortgage every month,
these same banks would quickly declare you in
default. But the rules are quite different when
the banks are the insurers underwriting the deal.
MF Global: Canary in the coal
mine? MF Global was a major global
financial derivatives broker until it met its
unseemly demise on October 30, 2011, when it filed
the eighth-largest US bankruptcy after reporting a
"material shortfall" of hundreds of millions of
dollars in segregated customer funds. [3]
The brokerage used a large number of
complex and controversial repurchase agreements,
or "repos", for funding and for leveraging profit.
Among its losing bets was something described as a
wrong-way $6.3 billion trade the brokerage made on
its own behalf on bonds of some of Europe's most
indebted nations.
Avizius writes:
[A]n agreement was reached in Europe
that investors would have to take a write-down
of 50% on Greek Bond debt. Now MF Global was
leveraged anywhere from 40 to 1, to 80 to 1
depending on whose figures you believe. Let's
assume that MF Global was leveraged 40 to 1,
this means that they could not even absorb a
small 3% loss, so when the "haircut" of 50% was
agreed to, MF Global was finished. It tried to
stem its losses by criminally dipping into
segregated client accounts, and we all know how
that ended with clients losing their money ...
However, MF Global thought that they had
risk-free speculation because they had bought
these CDS from these big banks to protect
themselves in case their bets on European Debt
went bad. MF Global should have been protected
by its CDS, but since the ISDA would not declare
the Greek "credit event" to be a default, MF
Global could not cover its losses, causing its
collapse.
The house won because it was
able to define what "winning" was. But what
happens when Greece or another country simply
walks away and refuses to pay? That is hardly a
"haircut". It is a decapitation. The asset is in
rigor mortis. By no dictionary definition could it
not qualify as a "default".
That sort of
definitive Greek default is thought by some
analysts to be quite likely, and to be coming
soon. Dr Irwin Stelzer, a senior fellow and
director of Hudson Institute's economic policy
studies group, was quoted in Saturday's Yorkshire
Post (UK) as saying:
It's only a matter of time before
they go bankrupt. They are bankrupt now, it's
only a question of how you recognise it and what
you call it. Certainly they will default ...
maybe as early as March. If I were them I'd get
out [of the euro]. [4]
The Midas
touch gone bad In an article in The
Observer (UK) on February 11, titled "The
Mathematical Equation That Caused the Banks to
Crash", Ian Stewart wrote of the Black-Scholes
equation that opened up the world of derivatives:
The financial sector called it the
Midas Formula and saw it as a recipe for making
everything turn to gold. But the markets forgot
how the story of King Midas ended. [5]
As Aristotle told this ancient Greek
tale, Midas died of hunger as a result of his vain
prayer for the golden touch. Today, the Greek
people are going hungry to protect a rigged $32
trillion Wall Street casino. Avizius writes:
The money made by selling these
derivatives is directly responsible for the huge
profits and bonuses we now see on Wall Street.
The money masters have reaped obscene profits
from this scheme, but now they live in fear that
it will all unravel and the gravy train will
end. What these banks have done is to leverage
the system to such an extreme, that the entire
house of cards is threatened by a small country
of only 11 million people. Greece could bring
the entire world economy down. If a default was
declared, the resulting payouts would start a
chain reaction that would cause widespread
worldwide bank failures, making the Lehman
collapse look small by
comparison.
Some observers question
whether a Greek default would be that bad.
According to a comment on Forbes on October 10,
2011:
[T]he gross notional value of Greek
CDS contracts as of last week was €54.34 billion
[US$72 billion], according to the latest report
from data repository Depository Trust &
Clearing Corporation (DTCC). DTCC is able to
undertake internal netting analysis due to
having data on essentially all of the CDS
market. And it reported that the net losses
would be an order of magnitude lower, with the
maximum amount of funds that would move from one
bank to another in connection with the
settlement of CDS claims in a default being just
€2.68 billion, total. If DTCC's analysis is
correct, the CDS market for Greek debt would not
much magnify the consequences of a Greek default
- unless it stimulated contagion that affected
other European countries. [6]
It is
the "contagion", however, that seems to be the
concern. Players who have hedged their bets by
betting both ways cannot collect on their winning
bets; and that means they cannot afford to pay
their losing bets, causing other players to also
default on their bets. The dominos go down in a
cascade of cross-defaults that infects the whole
banking industry and jeopardizes the global
pyramid scheme.
The potential for this
sort of nuclear reaction was what prompted
billionaire investor Warren Buffett to call
derivatives "weapons of financial mass
destruction". It is also why the banking system
cannot let a major derivatives player - such as
Bear Stearns or Lehman Brothers - go down. What is
in jeopardy is the derivatives scheme itself.
According to an article in The Wall Street Journal
on January 20:
Hanging in the balance is the
reputation of CDS as an instrument for hedgers
and speculators - a $32.4 trillion market as of
June last year; the value that may be assigned
to sovereign debt, and $2.9 trillion of
sovereign CDS, if the protection isn't seen as
reliable in eliciting payouts; as well as the
impact a messy Greek default could have on the
global banking system. [7]
Players in
the future may simply refuse to play. When the
house is so obviously rigged, the legitimacy of
the whole CDS scheme is called into question. As
MF Global found out the hard way, there is no such
thing as "risk-free speculation" protected with
derivatives.
Ellen Brown is an attorney
and president of the Public
Banking Institute. In Web
of Debt, her latest of 11 books, she shows
how a private cartel has usurped the power to
create money from the people themselves, and how
we the people can get it back. Her websites are
WebofDebt.comandEllenBrown.com.
Head
Office: Unit B, 16/F, Li Dong Building, No. 9 Li Yuen Street East,
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