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Prices of credit default swaps, insurance contracts on
major bonds used by large investors as a hedge, and a bet on the decline
of prices, rose this morning in European trading. This came in response
to the worsening financial market situation in Europe.
Over the last several weeks, we have written several analytical and investigative
pieces that have led us to one conclusion. The markets aren't going to recover
significantly for some time, because of the underlying structural problems in
the global economy. Today, we summarize the data and project the conclusion into
the future.
It started a few weeks ago in Europe. As the Greece situation gathered steam,
the U.S. Dollar, having already bottomed, became a place for money to hide as
things sorted themselves out. Now, as the Euro seems to be taking out handles
(price levels) on a daily basis, the dollar is starting to shoot straight up,
while U.S. Treasury bonds are also soaring. When the dollar and the U.S. bond
market rally together, it’s usually a sign that some sort of panic is in the
works. And the pace of this panic is so steady that it suggests that it could
go on for some time.
So what is the world afraid of? Well, it’s pretty simple. Europe isn’t going
to pay its bills any time soon, because it’s so structurally clunky that it’s
not able to generate enough economic activity to generate the tax revenues that
it would take to make a dent in its debt. Of course, neither is the U.S. likely
to ever pay all of its sovereign debt. But the difference, at least for now,
is that the markets seem to think that the U.S. has a theoretical chance of paying
its bills, while Europe, or at least parts of Europe aren’t ever going to make
enough of a dent in their sovereign debt to be worth hanging around for. So,
rather than waiting, money is leaving Europe and heading for the U.S.
But here’s where that argument gets a little tricky. The U.S. has its own problems.
Yes, there are still enough people working, making things, providing services,
and paying taxes, to keep things from totally imploding. Yet, there is a slow
and steady erosion of the U.S. economy that is ongoing. And that’s the part that
the mortgage market represents.
Over the last three months, Fannie Mae and Freddie Mac have been buying loans
from banks and mortgage companies that are at least 60 days delinquent. Fannie
and Freddie have now socked away billions of these questionable loans for future
reference – translation, hoping that someday they’ll be worth something. In other
words, Fannie Mae and Freddie Mac have been quietly bailing out mortgage companies
whose bad loan levels were getting to the point of making the companies vulnerable
to losses, and perhaps, in some cases, insolvency and bankruptcy.
At the same time, every time the FDIC bails out the depositors of yet another
busted bank, they take on the toxic assets on the bank’s balance sheet, while
the bank that “acquires” the bank gets whatever is in decent shape at the bank,
which usually means the accounts, the buildings, the computers, and the employees.
That means that a bank gets the good stuff, which makes its balance sheet look
better, and the taxpayer gets the worthless paper, making the taxpayers’ collective
balance sheet look worse. And yes, the FDIC is also conducting a de facto bailout
of the banking system, while protecting depositors. The FDIC, is also, by all
intents and purposes broke.
So far, the FDIC has about $400 million of worthless CDOs (Collateralized Debt
Obligations) on its books, but has made it clear that it thinks that there could
be as much as $12 billion worth of these bundled bonds of bad mortgages sold
to community banks by investment banks over the 2000-2008 period that could find
their way to the FDIC’s books as more banks go belly up in the ongoing unwinding
of the mortgage mess.
There may be as much as another $400 billion or more bad loans waiting to go
bust in the U.S., as Option rate mortgages (ARMS) reset over the next couple
of years. And where are all those bad loans going to go? You guessed it, the
bottomless pits at Fannie, Freddie, and the FDIC, which are financed by the U.S.
taxpayer.
Now it gets even murkier. There are lots of bets out there called credit default
swaps (CDSs) that may be worth billions of dollars. These are insurance policies
that big traders take out on financial instruments that they believe may be lose
value at some point in the future. There is no way of knowing how many of these
CDSs are there, or how much money they stand for. But, if they are anything like
the ones that were in place when the subprime mortgage crisis first broke, we
could be talking about hundreds of billions of dollars of bets against anything
that can be bet on, bonds, stocks, currencies, and so on.
At some point, the value of the CDS rises to the point where the buyer wants
to cash in. When this point comes, the buyer of the CDS calls the counterparty
in order to collect his money. If the counterparty has the money, it’s not a
problem. If the counterparty doesn’t have the money, they have to sell something.
Usually, the easiest things to sell are stocks, bonds, and currencies, which
is why when a bunch of the CDS bets go awry, the markets take a hit, although
no one knows about it until after the effect, since these bets are off the book
bets.
Getting a handle on the issue? Europe has problems now. But the U.S. is likely
to have a problem at some point in the future, because the mortgage bomb is imploding
slowly. If the market and the public can stay patient, well, we could continue
with this little charade for a good while. And that’s o.k. as long as Europe
is in worse shape than the U.S. But if something else happens, the markets may
not be so patient.
Here's what should be of concern to all citizens. If the FDIC only has $400 million
worth of CDOs on its books, then there is a potential $11.6 billion worth of
the "toxic" stuff out there waiting to land in Uncle Sam's open hands, which
may eventually find its way to the tab that the FDIC may present to Wall Street
investment banks who engineered the whole mess.
Conclusion
If you haven't figured it out by now, the key to the puzzle is the credit default
swap. No one really knows how much money is out there betting on anything. And
the CDS is, aside from exchange traded options, the vehicle of choice for big
money. It's anonymous, and it's relatively cheap.
But it's also an unknown. And now that the German government is tinkering with
short selling rules, and the SEC is putting in new circuit breakers to slow the
rate of descent of falling markets, those holding CDS's have a new set of issues
to deal with. The central question for them is whether their bets are still operating,
and if so, how will they be able to cash in?
The significant declines in the European markets overnight, are likely to have
been influenced, at least to some degree by CDS bets that need settling, and
that are requiring parties involved to sell something in order to pay the bet
off. That's what happened when the subprime mortgage market crashed. The bets
came due and the hedge funds on the wrong side of the bet had to sell liquid
assets, especially stocks to make good on the bet.
Global governments still don' get it. They can't legislate this stuff away because
there is too much money, off the books, that is out there floating around making
bets on reliably bad government policy. The bottom line is that when the bets
come due, those who want to live to bet another day have to make good. And when
enough bets go wrong at a similar time, that's when the selling accelerates.
Crazy? You bet, they bet, everybody bets. The problem is that at some point,
all bets come due, and when they do, real money is required to pay them off.
If your life revolves around leverage, the time when you have to pay off a big
bet is when reality sets in. This isn't going away any time soon.
We'll be on Twitter
some time today before the market closes with some updated comments.
Know when to sell and how to make money when the market falls. Get
a detailed trading plan in your pocket. Read Dr. Duarte's All
NEW Books "Market Timing For Dummies." and "Trading Futures For Dummies." The Trading Manuals for
All Seasons. Also Available As Kindle Books. |
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