CDS's and their Twisted Incentives

I love this stuff. I wrote some time ago about how the CDS market was dictating the rates that companies were forced to pay when trying to borrow money. This implied the CDS market knew best which is a dangerous president.

Today Henry Sender of the FT reported about how lenders who covered their loans through the CDS market are actually pushing their own borrowers into default so they can collect the CDS payoff instead of negotiating with the borrower. This is perverse and brings to light again the reality that these "derivative" contracts are insurance and if enough companies with significant debt are forced into bankruptcy, there will be great strains on companies who sold these products and we could see more "bail outs" in the near future if the government is stupid enough to continue throwing money after the idiots who wrote them.

The articles (may require subscription) states in part:

Credit default swaps, the derivatives instruments that have figured prominently in the global financial crisis, are now being blamed for playing a role in two bankruptcy filings this week.

Bankers and lawyers involved in restructuring efforts say they are concerned some lenders to troubled companies, such as newsprint producer AbitibiBowater and mall owner General Growth Properties, stand to benefit from a default because they also hold default swaps, which entitle them to payments in such events.

“We have seen CDS becoming a significant factor” when negotiations on out-of-court restructurings fail, said Alan Kornberg, the partner in charge of the bankruptcy practice at Paul, Weiss, Rifkind, Wharton & Rice, speaking generally. “We used to talk about the practice theoretically but now we see cases where it is hard to get lenders to agree to tender or to compromise and then you find out that these holdouts had significant CDS protection.”

Such exchange offers require the support of a significant number of lenders, 97 per cent in the case of bondholders in this case. But those who withhold support often have powerful incentives to do so, either because they hope to be made whole or because they are seeking to force a filing that would trigger payments under their credit protection agreements, bankers and lawyers say.

So lend with abandon because you can "cover yourself" with some of those profits from writing the loans by buying "protection" from whatever idiot is crazy enough to write a contract on the debt. This reality has much to do with why we are in the mess we are in and how our US spineless government continues to fail to regulate this industry or it's players and instead shoves cash into the accounts of incompetent idiots who wrote the contracts for the benefit of those who purchased the contracts. Now the government owns the banks that benefited from the bailout and the company of the largest number of idiots who wrote them. Is there a conflict here? Are there conflicts everywhere? Can the government "be the market"? Hell no.

Credit Default Swaps on US Government Debt

OK, correct me if I am wrong but the US currently has over $7 Trillion in debt floating around out there. Now, those are no small potatoes.

Correct me also if I am wrong, but our current financial mess, including the bailout of AIG, greatly owes it’s thanks to the CDS market.

A quick Wikipedia definition is in order here:

A credit default swap (CDS) is a swap contract in which the buyer of the CDS makes a series of payments to the seller and, in exchange, receives a payoff if a credit instrument - typically a bond or loan - goes into default (fails to pay). Less commonly, the credit event that triggers the payoff can be a company undergoing restructuring, bankruptcy or even just having its credit rating downgraded. Credit Default Swaps can be bought by any (relatively sophisticated) investor; it is not necessary for the buyer to own the underlying credit instrument.

Now can someone explain to me exactly WHO has the ability to guarantee or pay off $10 Million in US Government debt (the usual denomination for a CDS) multiplied by millions if the US Government actually defaulted on it’s debt?

Isn’t this what got us into much of the mess we are in? Idiots actually sold Credit Default Swap contracts on debt securities backed by garbage mortgages, car loans, credit card loans, personal loans, loans for leveraged buyout firms, loans to hedge funds and others taken out to buy yet more debt securities in a kind of vicious circle / pyramid scheme, loans issues by banks to firms they created to buy their own garbage securities so they would not exist on their over-leveraged balance sheets…

Come on now. Help me out. Why in the Hell hasn’t the CDS market been shut down? I am completely baffled by the fact that anyone is crazy enough to issue, buy or trade CDS’s right now since it has become painfully clear that the sellers of the shit have for years not had the collateral to back their issuance and this has been proven over and over again. These are “insurance” products that require no regulated capital to guarantee payment in case the debt they are written against actually defaults.

So why is this stuff floating around guaranteeing US Government debt? And why in the HELL is Geithner calling on the unregulated Hedge Fund industry to take $1 Trillion in new government money to buy more garbage debt from the defunct credit markets? Help me out here? I read an article this week that claimed the price of insuring $10 Million in US Debt had risen to $90,000 per year. Brilliant. Now who in the hell is going to pay the $10 Million if or when the US Government defaults? Isn’t the idea that there ended up layers of these “insurance” products valued at something like $70 Trillion that contributed greatly to the “credit crises” we now face? The idiots who originated the “insurance” products bankrupt their companies and to this day, the US Government is bailing out institutions like AIG with tax payer money so they can continue shoveling the cash to the counterparties of these instruments.

On top of that, the firms and the government agencies involved in the bailouts refuse to tell us who those counterparties are or why they don’t just force a settlement of these contracts and for all parties to take their losses and walk. Instead, our future tax dollars (cause none of this is today’s money, it is all being borrowed for us to pay tomorrow) are going directly into the coffers of God knows whose buddies and they are getting downright rich off of it.

I have completely had it. Our legislators are ignorant impotent pushovers. The people running the treasury are bailing out their buddies and the Fed is going to go bankrupt trying to “be” the credit market. The dollar, or the confidence in it, is in real long-term trouble. What in the hell is going on here?

If the Chinese were worried about US Government debt a year ago they should have bought ALL the CDS’s people were ignorant enough to write. Hell they could have bought US Government protection for $40,000 per $10 Million and be cashing out here at over 100% profit on the CDS contracts alone not to mention still collecting interest on the underlying debt.

Have I said enough? Shut down the CDS markets. Force settlements of all outstanding contracts and regulate the hedge fund industry TODAY.