Credit default slop, redux

By A.J. DiCintio

Busy living their lives, most people don't have time to memorize every last name of every last product hawked by the modern financial industry.

Therefore, I'll explain straightaway that the title plays with the name of the financial instrument called a "credit default swap" or "CDS," which is an insurance policy a lender buys to protect himself against default.

As for clearing up the business about "slop," I simply ask readers to think about the following two recent historical facts:

First, that dreams of very easy, very big money danced in the heads of AIG big shots when they sold boatloads of CDS's to banks looking to protect themselves against the astounding losses they would incur if the "sub-prime" mortgage market went south.

Second, that the stink filled bubble created by the "ownership society" dreamed into being by stupidly dogmatic, unforgivably airheaded politicians and regulators such as George Bush, Barney Frank, and Alan Greenspan and carried out by contemptibly irresponsible big bankers did inevitably burst, creating a financial crisis that doomed the nation to long term pain and sent AIG reeling toward bankruptcy — until what Barry Rithholtz calls "Bailout Nation" stepped in.

Here's how mcauleysworld — to whose effort I add three more essential components — did its part to make this sordid, painful history easy to understand:

[The Fed's easy money policies and the "ownership society" scam] ¨ Fannie & Freddie ¨ Toxic Mortgages ¨ Toxic Mortgage Securities ¨ Credit Default Swaps ¨ Collapse ¨ Bailout ¨ [Today's Ugly "New Normal"]

Having established that Washington's politicians conspired with Wall Street and its K Street lobbyists to betray Main Street in a manner so disgustingly ironic "too big to fail" AIG was saved from bankruptcy by taxpayer money that paid Goldman Sachs and foreign banks 100 CDS cents on the dollar, I now turn to "redux."

Here, thanks must go to John Mauldin (johnmauldin.com), whose interpretation of data compiled by economist Kash Mansori warns that American banks are at it again, having currently sold "$120 billion of credit default swaps" to European banks seeking protection from default by one or more of the PIGS [Portugal, Ireland, Greece, Spain].

Regarding those transactions, Mauldin makes two insightful observations:

"European firms have been betting that a PIG default will happen sooner rather than later, while US firms have been betting that default would happen later or not at all."

"When, not if, Greece [highly likely to be the first PIG to go belly up] defaults, US banks are going to have to dip into capital to pay those commitments. Capital that should be available for loans to businesses but will have to be paid to European banks instead."

Ah, yes, for nearly three years, the gambling-losses-impaired balance sheets of big banks have mandated tight lending policies, thereby causing the nation an enormous amount of pain as businesses (especially those defined as "small") are unable to grow and add jobs.

Imagine, then, what the state of the union will look like after another CDS debacle, one which, according to Maudlin, will cause bank problems "too big for the FDIC to handle," thereby wiping out shareholders and forcing bondholders to accept some really nasty haircuts.

However, as significant as they are, those losses won't be our biggest problem; for the frightening truth is that economic disasters inflict their greatest pain upon the mass of ordinary citizens, therefore ripping at the nation's very fabric.

Surely that truth explains why Mauldin closed his brief commentary with this agonizing question:

"But why are investment banks allowed to mix [that kind of] risk with their commercial banks?"

To which can be added these questions.

Why aren't credit default swaps required to be sold and traded in the transparency of an exchange?

Why are individuals and institutions that own not a penny of a borrower's debt permitted to purchase credit default swaps against that debt, a practice which greatly increases speculation in the CDS market, not to mention increasing the amount of money insurers must pay in the event of default?

Of course, Mauldin's fundamental question must be rhetorical; for this data driven (not dogma worshipping) financial expert who now regrets his support for the repeal of Glass-Steagall (which prohibited banks from getting into the securities and insurance businesses) certainly knows the lion's share of the answer lies in the power of big money.

Exacerbating the implications of that reality are these two truths:

The nation cannot trust Democrats to reform anything; for it is now a self-evident truth they perceive every problem exclusively as an opportunity not to be wasted in their unending quest to bloat the size and power of government.

The number of honest Republican reformers is increasing; however, their influence in the case at hand is blunted by advocates for Wall Street Business as Usual (think, for example, Mitch McConnell) who use Washington's growth-stunting, "make work" mountain of unnecessary or duplicative regulation as a cover for allowing the financial industry not just the opportunity to do the nation great harm but, having done it, to pick the people's pockets through the most perverse welfare scheme one can imagine.

Yet all is not lost; for the ordinary Americans who populate the Tea Party movement — including owners of truly "small" businesses who greatly enrich this nation without trading in currencies, commodities, and credit default swaps — have never had a problem with walking and chewing gum at the same time.

Moreover, by nature, they recognize the danger of toxic slop in all its forms and, with experience and common sense as their guides, are disposed to join with like-minded fellow citizens, whatever their political leanings, in getting down to the hard work of cleaning it up right.

© A.J. DiCintio