What a Week

I haven't been blogging this week because I didn't know what to say. There's a horrible fascination in watching everything fall apart. I remember the sensation from 9/11, we were all unable to stop watching the instant replay of the falling towers.

However, as the government took step after step to staunch the bleeding, and the credit markets remained stubbornly frozen, my suspicions grew that nothing is working because the Feds are fighting the wrong war. Part of the problem, of course, is that no one believes (I certainly don't) that Paulsen knows what he's doing. He's just hoping that if he throws enough money, something will open up. Injecting capital into the banks may help. But I believe the true problem is the credit default swaps; and until we solve that, the credit markets are going to stay frozen.

For those of you who haven't listened to last week's This American Life, as I recommended, here's a brief summary of credit default swaps, as I understood them from the show:

The basic credit default swap or CDS is insurance against a bond issuer going bankrupt and defaulting on the bond. Just like Lehman Bros. is about to do to me. Company A issues a bond; company B buys it, because the interest rate is so good. Company B, however, is worried about the stability of company A; so they turn to company C, who writes them a credit default swap. Company B agrees to pay company C a percentage of the income stream it's getting from company A's bond; in return, company C agrees to pay company B the full face amount of company A's bonds that company B bought, in case company A goes Tango Uniform (as they say in the military).

Obviously, company C (who wrote the CDS to company B) has more faith in company A's financial soundness than company B does. And they really like that steady stream of income.

Now it starts to twist. Investor D decides that company A isn't a good prospect. So he goes to company C, and says, I want a CDS against X dollars' worth of company A bonds. Investor D doesn't own any company A bonds; he's just betting on the come. He's doing the credit equivalent of a short sale: he's betting that company A will go broke; and he's paying company B an income stream, some percentage of the interest he'd be getting if he owned the bond, in exchange for company C's promise to pay him X dollars (the amount of bond he's buying a CDS on) in case company A goes under. And company C sells him the CDS; another steady stream of money.

Company C has now promised to pay two different parties the face value of a bond that only one of them owns, in case company A goes broke.

Now multiply that by hundreds of deals, all over the U.S. and probably all over the world. And add to that the final twist: thanks to Sen. Phil Gramm's Commodities Futures Modernization Act of 2000 (remember the guy who said we are "a nation of whiners"?), all these deals are unregulated. They're "over the counter."

That means they are all private. There's no central place, like a stock market, that has a record of who has written what CDS against what debt obligations. We can be pretty sure, however, that some or all of the major institutions were writing CDS's against the AAA rated sub-prime backed securities that everybody was buying. After all - they're not going to default, and the housing market will never stop rising. Until it didn't. Until the loans everyone was pushing began to default.

Because if you wrote CDS coverage for, say, a mortgage-backed security worth half a million dollars, you're on the hook for the dollars if that security ceases to pay interest. Do you have the dollars? Or are you so leveraged that you'd have to borrow in order to meet the obligation? Remember, all these people operated on borrowed money, all the time.

Now it's the end of March 2008, and Bear Sterns has just gone under. Immediately everybody who wrote CDS's on Bear Sterns debt has to pony up cash. They know who they are; and their counterparties know; but nobody else does, because CDS transactions aren't regulated and are private. You didn't see any news about people paying off CDS on Bear Sterns.

Every time since March that a major financial firm has gone under to the point where they default on their debt, more of these chickens have come home to roost. Every bank knows what their own position is; but because of the private nature of the transactions, they don't know what anyone else's position is. And nobody knows what the real position of the mortgage-backed securities is.

And that, compadres, is why banks are not lending to each other. They don't know who's sitting on CDS obligations that exceed their entire net worth.

I'm not an economist; I'm just a techie, and nobody's going to listen to me. But frankly, I see only one thing the government could do that would really open this up: Force an audit. Require every financial institution to compile and publish a list of all the CDS they have written. Only then will we be able to estimate the real scope of the damage, and make realistic plans about how to deal with it.

The truth shall make you free.