Monday, January 14, 2008

Subprime crisis; CDS “global financial meltdown”

We're not going to pretend to know exactly what this all means but it's top rate jargon relating to the selling of a fiat currency and the ability to digitize as many units as one would wish or not. Or not in a credit crunch...

When less digitized money is input (or even taken away) interest rates go up as markets close in on themselves and the bankers get to buy all the goodies back at pennies on the pound. lol.

Some get screwed some get rich??? who really knows what the banking industry and govt actually do... we can just guess from our experience as they don't explain it in school.

Not merely a subprime crisis; CDS and “global financial meltdown”

Here’s Wolfgang Münchau, writing in Monday’s FT:

If this had been a mere subprime crisis, it would now be over. But it is not, and nor will it be over soon. The reason is that several other pockets of the credit market are also vulnerable. Credit cards are one such segment, similar in size to the subprime market. Another is credit default swaps, relatively modern financial instruments that allow bondholders to insure against default.

This is a theme that the FT’s markets team picked up on Friday. Credit default swaps, it seems, are in for a lot of column inches in 2008. CDS might just be the new subprime.

As Münchau explains, the reasons for that are principally linked to the now-likely prospect of a US recession.

At a time of low insolvency rates, many investors used to consider the selling of protection as a fairly risk-free way of generating a steady stream of income. But as insolvency rates go up, so will be the payment obligations under the CDS contracts. If insolvencies reach a certain level, one would expect some protection sellers to default on their obligations.

Last week Bill Gross of Pimco gave a round-about figure of $250bn as a potential loss from CDS contracts defaulted. Commenters on FT Alphaville picked up that figure and took umbrage with it: pointing out that some cases -namely Delphi - CDS contracts are taken out for up to ten times the value of the bonds they insure.

Mr Münchau too, sees reason to be bearish:

His [Bill Gross’] calculation assumes that the corporate insolvency rate would return to a normal level of 1.25 per cent (measured as the default rate of all investment grade and junk debt outstanding). As the entire CDS market is worth about $45,000bn, $500bn in CDS insurance would be triggered under this assumption. The protection sellers would probably be able to recover some of this, so the net loss would come to about half of that. This estimate is very rough, of course. Most important, it is based on the assumption that the hypothetical US recession would not turn into a prolonged slump. In that case, one would expect corporate default rates not merely to return to trend, but to overshoot in the other direction.

So one could take that calculation as a starting point. A downturn lasting two years could easily trigger payments streams of a multiple of $250bn.

Which puts the potential scale of a CDS crisis above 2007’s subprime troubles. A long recession in the US would be disastrous - far worse, perhaps, than any in the past. The 1973-75 recession was bad enough, but consider its more widespread impact, had there been CDS contracts around:

It is not difficult at all to see how the CDS market has the potential to cause serious financial contagion. The subprime crisis came fairly close to destabilising the global financial system. A CDS crisis, under a pessimistic scenario, could produce a global financial meltdown.

This is not a prediction of what will happen, merely a contingent scenario. But it is contingent on an event - a nasty and long recession - that is not entirely improbable.

Scares us here at Secret Teachings.

No comments: