Who would be a central banker? Their choices today are awful. The problem facing the financial system come from one common place….credit and the excesses of easy credit with a corresponding decline in the punishment for getting it wrong. The problem stems from having too much money chasing too few assets. The result was that asset prices were bid up to ridiculous levels, investors were prepared to accept more and more risk to get returns and the system fed upon itself. All sorts of exotic sounding things sprang up…Derivatives, Credit default swaps, subprime junk…a literal explosion in the amount of liabilities out there…liabilities built on liabilities built on liabilities…all interconnected, held in increasingly complex webs built by PhD Mathematicians. It all looked great on paper.

The problem now is that those who took such huge risks are being bailed out with OUR money. They aren’t being allowed to fail. Sure, if they are allowed to fail, some jobs will be lost. Some millionaires will go bankrupt, some centuries old institutions that departed from sensible money and risk management, seduced by advanced mathematical models they didn’t understand that promised vast returns, will sadly disappear from our markets and life. It’s bad, but its not all that bad.

In saving these companies form their folly, the price we pay will be even greater. We will have to cover their losses. These losses can’t be recovered from taxation. That burden is already far too high. Instead, they will be covered through debasement of the currency. When we take away the cost of failure and reward excess risk taking with ordinary, hard working citizen’s savings, pensions and standard of living, I think it’s a price too high to pay. Let them fail.

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Tags: Credit Default Swap, Financial, Money Markets, Saving, UK Banks

A CDS or credit default swap is an instrument like an insurance contract. It allows the holder to the Credit default swap to claim money from its issuer (usually a bank) in the event that another third party defaults on its obligation to repay the money that was lent to it. It’s a kind of insurance against going out of business.

In the last few years, this market has exploded from $1tr to about $60tr as all sorts of financial institutions sought of offset risk in their dealings. So Goldman Sachs lends $10bn to Barclays bank. Goldman wants to offset the risk of Barclays going out of business. Goldman goes to AIG and asks them to write a credit default swap. AIG looks at Barclays and comes up with a premium….let’s say $50m. Then AIG, knowing that if Barclays goes out of business they’re on the hook for $10bn, offsets that risk to another issuer, let’s say, Lloyds of London.

It may even package up all its insurance policies that it’s written and asks Lloyds to insure against them all going bust…and so on and so on. The bottom line is that this type of risk was passed around and around until everyone had a little bit of it but it was unclear who exactly was the insurer of the initial risk. This is the CDS market, all be it a little simplified.

Now, here’s the bad news about this market…it is HUGE. The insured liabilities are around $60tr. That’s one year of GDP for the entire planet.  Here’s the really bad news…it’s totally unregulated. The reason the banks are so hesitant to lend…the factor that is actually preventing them from lending…is this market.

This is how banks are thinking. If we can just get through this crisis, we will have a huge market share…we must survive. What do we need to do to survive? We must not run out of money or the ability to raise capital. Hence, they are hoarding capital. Even though the government is throwing money at them like a drunken sailor in a lap dancing club, they are taking it but not lending it. They don’t trust each other…they can’t figure out how big the liabilities are which are owned by other banks in the vast CDS market.

They know more high profile bankruptcies are coming and they can do little about it. It then could become like a chain reaction. Let’s say company A  goes bust, Bank B is owed a $500m in a loan it made to company A. Bank B asks it’s insurer, Insurer C for the $500m for the CDS insurance policy payout. Insurer C can’t pay it or raise it and they go bust as a direct result of it. Bank B can’t pay its obligations to the people who it sold insurance to on Insurer C collapsing….then Bank B goes bust. This is the chain reaction nightmare scenario that is unfolding before the eyes of senior bankers and insurers…but they haven’t slept for days and are wide awake and terrified.

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Tags: Barclays, Credit, Credit Default Swap, Goldman Sachs, Money Matters, UK Banks