Wednesday, April 22, 2009 - Vol. 11, No. 100

Derivative “Whiplash”
Signs of Progress as Wall Street’s Riskiest Dealers Wise Up, But Has the Real “Big Bang” been Averted?
(A Follow-up to our Special Report on “Demon Derivatives”)

Dear A-Letter Reader,

A shocking Bloomberg headline came across the wire last night… “Credit Default Swap Market Shrinks By 38% as Dealers Cut Risks…” it said. According to Bloomberg, this was the end result of the “Big Bang Protocol,” as it’s being called in the financial world. But what is the big bang protocol?

Well, as you may know, CDSs are unregulated instruments. They’re traded over-the-counter, sometimes through clearinghouses like the International Swaps and Derivatives Association (ISDA).

As such, the major dealers in the CDS markets have to come to a consensus before making any fundamental changes to the rules. Much like the way a cartel works.

Well, these dealers got together and made a massive overhaul earlier this month. Ironically, AIG – the government-subsidized poster child for CDS madness – refused to comply. Some 2,000 other firms went along with it, and the market for Credit Default Swaps is already starting to thin out…

But will this “Big Bang” be enough to avoid the real Big Bang that’s been brewing in the CDS markets for over a decade? Probably not. Here’s why…

(Click here for a refresher on Chairman Pugsley’s “Big Bang Theory” of the CDS markets)

Putting Lipstick to Pig…

“We're talking about minor tweaks to contracts,” John Avery of Sungard admitted when asked about the “Big Bang” and the real effect it would have on the industry.

Make no mistake. They are standardizing CDS contracts and pricing terms…with the hopes of eventually automating the clearing process…and even running everything through a central clearinghouse to ease the counterparty risk woven throughout the global financial system.

And they’re tentatively expecting regulation could begin around May or June of this year. Taken together that makes for a very cheery press release…maybe even a few minutes of praise on CNBC.

And in reviewing all the press releases, interviews, and insider reports…I’m starting to feel like that was the goal here. Some positive spin. A bit of the old "pointless campaigning," if you will. “It's some good positive change after six months of negative news,” was another one of Avery’s comments on the whole event.

Well friend, we gave them a few days to enjoy it. But now it’s time to start poking holes in some of their plans…

And An Ugly Pig at That!

First, let’s start with Bloomberg.

They’re not usually given to sensationalism, but I can’t be convinced that they really believed the headline they were throwing out there. The market didn’t shrink by 38%. The ISDA – a non-compulsory, opt-in regulatory structure to add legitimacy to CDSs – measured a 38% drop in trading volume.

Remember, CDSs are unregulated instruments. So they don’t all have to be registered with the ISDA. And a quick look at some data from Markit – a CDS pricing and valuation tool – confirms that they’re not. In mid-2008 – while the ISDA’s measure of the CDS market hovered around US$60 trillion – Markit was reporting trading volumes of about US$60 trillion.

So unless you believe that every CDS contract is constantly being traded, then the ISDA’s measure is hardly accurate. As such, we can’t assume that their measures represent prevailing trends throughout the industry…so we can’t assume the CDS market is even shrinking.

Indeed, it could even be the case that the market grew. Perhaps dealers and buyers were spooked by the new “Big Bang” stance, and started to avoid the ISDA where they’d done business in the past.

But if the “Big Bang” isn’t reducing the insane amount of counterparty risk in CDSs by thinning out the markets, won’t some of the other proposed changes have that affect?

Hardly. Rather, the push to create a central exchange for CDS contracts could end up creating…

The Biggest of the “Ultra-Mega-Too-Big-To-Fail&rd... Monstrosities

I mean, let’s step back and really take a look at this.

Banker X buys a CDS on Banker Y’s bonds from Banker Z. Banker Z turns around and buys the same CDS from Banker A in the UK for a lower price. Banker Z just turned a quick profit, but he’s also building a daisy-chain of interdependency, a web that could drag down Bankers A-Z if any one of them goes broke at a bad time. That’s what we’ve been seeing at AIG…and what’s been giving CDSs a real black eye in the media lately.

So their solution? Let’s put them all on an exchange! That’s it! One big central counterparty, like the New York Stock Exchange. They’ll have the incentive to keep a close eye on margins and other requirements, and they might add an extra layer of protection to the whole deal.

Now maybe a year ago that would have seemed like a great idea. But there’s already a ‘central counterparty’ in the CDS business…they’re called AIG. Ask US$180 Billion taxpayer dollars how that one’s worked out so far.

Now, to be sure, AIG wasn’t the only dealer in the CDS business. So a central exchange could take the problems we’ve been having with AIG and boost them up to the next level. And if AIG couldn’t fail, then it would be simply impossible for a central exchange to fail without sucking down most of the Western World’s financial system.

You might rebut that AIG was run with a level of discipline and intelligence more at home in a frat-house than the executive suite of the NYSE. I’ve got no argument for you there.

But remember, if they established a central clearinghouse for CDSs…and they implemented honest regulations, where CDS sellers had to keep enough reserves on hand to satisfy all their obligations…and everything was transparent and legitimate…then there wouldn’t be any profit in it, and we’d be talking about insurance right now, not the obscure “Credit Default Swaps.”

We don’t see this as a significant, material change in the CDS markets. It’s a campaign promise...good marketing…a press release…tantamount to a Treasury Secretary telling you the banks are “well-capitalized.”

Make no mistake; this one wasn’t the Big Bang. That event is still coming, and it could devastate anyone caught unprepared.

(Read Chairman Pugsley’s Full Report on “Demon Derivatives” to prepare yourself to profit as unwinding Credit Default Swaps rip through the financial industry and the economy)

Yours in Personal Sovereignty,
MATTHEW COLLINS, A-Letter Editor