Howard Hill in his recent book Invisible Leverage has given us a real simple and clear definition of why Credit Default Swaps (CDS) are so attractive and lucrative. You can find some of the chapters of that book online at Howard’s blog site, http://mindonmoney.wordpress.com/2010/04/20/invisible-leverage/. “ Most Corporate Credit Default Swap (CDS) contracts only charge 1% to 3% of the face amount of the bond as an annual payment and the capital requirement is only about 5% of the face amount.
If a corporate bond issuer goes into default, the typical decline in value of the bond is around 30%. For a corporate CDS investor, that’s a 600% return on the 5% capital deposited to enter into the contract. In the subprime CDS market, a 5% capital bet could return as much as 2000% if the bond represented became worthless. Compare that to short sales, where if a stock goes to zero, the maximum return on capital is 200%.
The CDS market was [and is] a goldmine for betting against companies. Bearish traders who previously had shorted company stocks discovered that the relatively small amount of capital and low payments for CDS brought them much higher returns when they correctly targeted companies that were in trouble. “
What most of us don’t understand is why I call CDS’ weapons of mass destruction. I think most of us think these were investment plays made by big players who were greedy and they getting what they deserve, which is true for those who were hedging with CDS’. But what they were betting on is bonds and credit instruments that would become worthless and they acted to insure they did.
What most people don’t understand that those bonds they were taking down were monies invested by school districts, retirement funds of corporations, hospitals, and other institutions that were investing in what they thought were very secure and conservative investment instruments. At the core of the SEC’s investigation and allegations of the activities at Goldman Sachs was that a hedge fund investor, Paulson, brought a group of worthless paper to Goldman and Goldman then pawned them off to investors without telling them that they were toxic. Those investors, like hospitals and retirement funds lost their shirts and Paulson banked $1 Billion on the play and Goldman pocketed $15-20 million in fees.
That’s why the trades were in my mind criminal and that’s also, at first, why the regulators looked the other. First you have to understand that the CDS trades were “over-the-counter” and therefore no public disclosure was required or for that matter no requirement to show those trades on corporate balance sheets as they were not required by regulations.
Secondly, the “Tea Party” gang and a lot of Americans believe that the government should not be bailing these boys out. On the moral side of the issue I agree, but as Howard so clearly pointed out in his book the size and scope of the impacts left our government and the governments of the EU no choice. Think about this: “Just how large is the CDS business, and why is it so important that the taxpayers should subsidize the largest participant in the business taking over the fifth largest? In the Bank for International Settlements (BIS) June 2007 Triennial Central Bank Survey, it was reported that the CDS business grew to a face amount over $45 trillion, up from an amount so small that it wasn’t even reported three years earlier. This staggering sum was twice as much as the combined value of all stocks on the U.S. exchanges at the time, and nearly three times the size of our national GDP.”
If not rescued by the sovereigns, the impact on the world’s economy would surely have been so great that I don’t think a “recovery” would have been even possible. However, what is also criminal is these practices now continue unabated and still unregulated. The very same investment firms are playing the same games. Goldman Sachs is going to offer up “Fabulous Fab” as a sacrificial lamb and claim that at the top, they had no idea this “rogue” trader was making the moves he was making in the market. What a crock. An average great trader wins 55% of the time and loses 45% of the time. His profit is the difference. These numbers reflect the really hot traders with exceptional instincts. Goldman Sachs wins 95% of time! What? How? True they have inside info which in itself is illegal and secondly they are making their massive profits and paying obscene bonuses because of what should be criminal activities plain and simple. We all know what happened to card cheats in the old west. Well these guys, the Goldman Sachs, Lehman Brothers, JP Morgan Chase, and hedge fund gurus of the world are the cheats of Wall Street, not that I am advocating a hanging. However, I am advocating they should make restitution and I am advocating that our government regulators should be given the tools by law to make sure this never happens again. Those tools should include some jail time for the Fabulous Fabs and the Biffs and Buffies of Wall Street, but more importantly their bosses, much more importantly their bosses. You know, if Fabulous Fab gets 5-10, then his boss should get 10-20. Something like that sounds right, doesn’t it?