Greek Credit Default Swaps

Published: February 06, 2012

03 February 2012

Monday night I sent to my free mailing list a link for a Jim Sinclair’s interview; he was anticipating that some-time this week, the International Swaps and Derivatives Association (ISDA) to rule foul was fair; that a proposed 70% haircut in Greek sovereign debt would not qualify as a default event. Well of course it would! It would be no different than if your home burnt down and the insurance company that sold you fire insurance refused to pay, claiming your home is not really gone; it only experienced a rapid, high-temperature oxidation process that transmuted the lumber in your house into carbon dioxide and trace minerals.

Mr. Sinclair didn’t mention the names of the five-big banks, so I went to the Office of Comptroller of the Currency (OCC) website to see which banks had the largest derivative positions, as it’s logical that these banks would be the banks in need of a quick fix. The OCC last updated this list in the first quarter of 2008, so names may have changed in the past three years.

No matter, using the list provided by the OCC, clients of these five banks’:

J.P. Morgan
Bank of America
Citibank
Wells Fargo (as it acquired Wachovia during the 2008 credit crisis)
Hong Kong, Shanghai Banking Corporation (HSBC)

seemed to have purchased credit derivatives to either make whole their Greek bond positions in the event of a default, or as a speculation for hedge funds making a leveraged bet on a sure thing.

Had the ISDA made this ruling this week, and released it to the financial media, it would have been a major market event, as this ruling would have allowed five major US banks to “legally” renege on their contractual and moral obligations to their counter-parties for these Greek Credit Default Swaps (CDS), but at what cost to the people they sold these CDS too?

The problem is these banks created a moral hazard by selling CDSs on Greek debt by the trillions in face value, to clients with AND without exposure to Greek default, only to pocket the commissions and fees. They assumed they would never have to payout on these “hedges” as the “policy makers” would never allow Greek debt to come to the point of default. This has happened before in America’s “regulated markets”; AIG in 2008 had this exact CDS model with US sub-prime mortgage, a real money maker for AIG – until sub-prime mortgages began to default by the billions-of-dollars.

As you can see at this link for the yield to the Greek 10yr bond, in the past eighteen months, yields have risen from 5% to 35%. It’s hard to believe that anyone on the wrong side of such an extreme market event, in a trillion dollar market, would not find themselves in an untenable position, in dire need of an exit. This situation is a waving RED FLAG that reported bank earnings on Wall Street are not what CNBC would have us believe.

Should Greece default on their bonds, counter-party claims larger than the US national deficit might be pending on these banks, a sum they could never make good on. That is not a wild guess on my part; the Bank of International Settlements latest statistics lists the total notional value for Credit Default Swaps (November 2011) over 32 trillion dollars, see table #19 in the link.

Greek CDSs are only a small part of this 32 trillion, notional value market. So, if Wall Street defaulted on their Greek CDSs, let’s assume just a tiny-trillion in notional value, the remaining $31 trillion CDSs written by these same banks (and others) for muni, corporate and sovereign bonds would become worthless as hedges for the bonds they were bundled with. The “risk” these CDS were allegedly “offsetting to those who could better bear them” (the American taxpayer), would soon be re-priced into the global bond market; overwhelming the efforts of the world’s central banks to keep interest rates contained within their “designed parameters.”

But bond yields didn’t spike up this week; so was Mr. Sinclair wrong? Not about the situation Wall Street finds itself in. Where he missed the mark was believing it was possible the ISDA would pull-the-trigger this week, ruling that a in any event, a Greek default was in fact no defaults at all, but an unfortunate situation that left the other side of big banks’ CDSs with no legal recourse to the tune of a few trillion dollars. Such a ruling, if made public, might just result in a panic in the global bond markets. So, the ISDA must have decided to kick the can down the road, and will continue to do so until they run out of road.

Maybe Mr Sinclair was the victim of a little dis-information, an attempt to discredit him. Speaking for myself, they failed to shake my faith in Mr Sinclair’s opinions on the markets. Like all market prognosticators, he makes some good, and some bad calls. Compare Mr. Sinclair with the following quotes by the twisted genius of central banking -Doctor Bernanke.

- Quotes from Chairman Bernanke -

November 21, 2002: “--- under a paper-money system, a determined government can always generate higher spending and hence positive inflation. Of course, the U.S. government is not going to print money and distribute it willy-nilly.”

October 04, 2006: "If current trends continue, the typical U.S. worker will be considerably more productive several decades from now. Thus, one might argue that letting future generations bear the burden of population aging is appropriate, as they will likely be richer than we are even taking that burden into account.”

March 28, 2007: "The impact on the broader economy and financial markets of the problems in the subprime markets seems likely to be contained."

May 17, 2007: "We do not expect significant spillovers from the subprime market to the rest of the economy or to the financial system."

Feb. 28, 2008: "Among the largest banks, the capital ratios remain good and I don’t expect any serious problems of that sort among the large, internationally active banks that make up a very substantial part of our banking system."

June 9, 2008: "The risk that the economy has entered a substantial downturn appears to have diminished over the past month or so."

July 16, 2008: “Fannie Mae and Freddie Mac are "adequately capitalized" and "in no danger of failing."

December 05, 2010:

"One myth that’s out there is that what we’re doing is printing money. We’re not printing money. --- The money supply is not changing in any significant way. What we’re doing is lowering interest rates by buying Treasury securities."

-End Bernanke Quotes-

A quick look at the chart below proves that Doctor Bernanke is a liar, and CBS is either ignorant of the simple statistics of “monetary policy”, or complicit with the Federal Reserve’s hyper-inflationary monetary policy.

That Bernanke dude has made some major bonehead predictions in the past. On any major topic that impacts retail investors, has taking actions on any of his market or economic insights proved profitable? None that I’m aware of! But the main-stream media still takes him seriously, as they live from one day to the next in a blissful ignorance of the pending disaster in the market. For Time magazine to select Doctor Bernanke their 2009 Man-of –the-Year, was a no-brainer choice in more than one sense of the term.

Denial is more than a river in Egypt; denial of market forces is now the basis of global central banking:

"Now that I am out of government, I can tell you what I really believe. Central banks are now so heavily influencing asset prices that investors are unable to ascertain market values. This influence is especially evident, with the Fed's purchase of government bonds, which has made it impossible for investors to use bond prices to learn anything about markets.
- Kevin M. Warsh: Former Federal Reserve Governor. Comments made to the Stanford University Institute for Economic Policy Research, 25 Jan 2012.

CNBC would never send a reporter to Stanford University to cover a former Federal Reserve governor wanting to clear his conscience. Rather they have chosen to pass the Davos party-line to their viewers; that the Federal Reserve and now European central banks’ purchases of government bonds are honest efforts to “stimulate economic growth”, while intentionally keeping their viewers ignorant of the pending catastrophe rising bond yields, and declining bond values must have on $32 trillion in CDS written on the global bond markets.

Don’t fool yourself; people at the highest levels of government and finance don’t care if you or I die tomorrow. What they do care about is maintaining a plausible appearance of solvency in their banking systems, not for the benefit of the general population, but what they would lose should JP Morgan or Goldman become insolvent in a derivative disaster. Reading between the lines of media coverage for the continuing negotiations between Greece, its creditors and the buttinskys from the Fed and ECB, I suspect many CDS written on Greek government debt are currently in the money, and would be exercised, but for the interference of government on both sides of the Atlantic.

These CDS are a big problem, but they are only a symptom of the much larger problem; the American and European political and banking elite have suspended the enforcement of contract and bankruptcy law when it suits their purpose.
These laws regulate the economic behavior of private citizens, and have existed, and served society well for centuries. These Greek CDS are contracts written by lawyers representing both counter-parties, with specific terms and obligations agreed to and specified in writing. Governments and their central banks have now inserted themselves in this private commercial matter, and are now acting as biased arbitrators in the settlement of private contracts. This tells us that American and European “policy makers” are acting independently of their lawful powers to deny the injured parties of a CDS contract seeking specific performance in a court of law.

There are larger issues here than who wins and who loses in the bond market’s Greek tragedy. The 20th century had no shortage of tragedies, but possibly the biggest was the refusal of totalitarian states to respect contract law. To Lenin’s Bolsheviks, contracts between two private parties was made illegal, as the only legally binding relationship allowed an individual in Marxist Leninism was to the state itself. With Mussolini’s fascist, and Hitler’s national socialist states, contracts involving issues of debt between private parties were allowed and enforceable in the courts as long as specific performance in a private contract wasn’t contrary to the state’s “policy.” Step by step, America is drifting away from our constitution, and heading toward a place you won’t like.

Market Update

After two weeks of trying, the Dow Jones now finds itself above its high of last April, and recorded it first BEV Zero in the Bear’s Eye View chart below since 29 Apr 2011.

For the bulls, having the Dow Jones breaking above the high of last year is a good sign, a necessary first step if the stock market is to move above its last all-time high of October 2007. To advance to a new all-time high (BEV Zero in the BEV chart below) the Dow Jones must increase another 1,303 dollars, or 9.19 BEV points from Friday’s high. Gaining 10% in a few months is no big problem, if we are in a bull market.

So, are we in a bull market? Well, according to Kevin M. Warsh: Former Federal Reserve Governor in his comments made to the Stanford University Institute for Economic Policy Research, 25 Jan 2012 (see above). There are good reasons to suspect that the Dow Jones and most other financial asset prices are only going up because central banks are interfering with the price discovery mechanism of the markets. Or as Mr. Warsh put it: “Central banks are now so heavily influencing asset prices that investors are unable to ascertain market values.” Whether or not the Dow Jones is in a bull market is really a mote-point as far as I’m concerned; as the market’s legitimate supply and demand forces have been, and will be suspended until further notice, or until Mr Bear gets really, really mad! Let’s just call the current rise in the Dow Jones a BS Market.

Well it is! Since 2000, trading volume has been out-of-whack; we need to look at the relationship between volume and the Dow Jones from 1929 to 1933 to see how things were before Chairman Greenspan inflated the High-Tech bubble. During the 1920s bull market, volume increased briskly, and then spiked in October – November 1929 when panic gripped the bulls in a rush to exit the market during the crash of 1929. But after the crash, as Mr Bear began grinding down what was left of the Dow’s valuation for the next two and a half years, daily trading volume declined by 89%.

Then, beginning in July 1932, at the bottom of an 89% bear market decline in the Dow Jones, the Dow Jones began its best year in history, a 52 week, 158% gain as trading volume exploded. This fantastic gain in the blue-chips came in two pulses of daily trading volume. The first was a relief rally off the Dow’s July 1932 bottom, which was spent by November, but the Dow Jones itself was up nicely from its July bottom. Incredibly, the second pulse in trading volume was ignited only weeks after

Emergency_Banking_Act

– it’s true!

Now look at what trading volume has done since 2000. The first fly-in-the-ointment was seeing the Dow Jones decline 38% as trading volume exploded 74% from January 2000 to October 2002. Since 1900, nothing similar has ever happened. Then, from the traumatic bottom of the second deepest bear market the Dow has seen since 1900 (March 2009), we now find the Dow Jones less than 10% from taking out the high of October 2007, as daily trading volume has been collapsing for the past three years.

These are not the natural market price movements and volume trends found in a functioning stock market. We are observing a market being manipulated at the highest levels of government and finance. This is going to end in tears.

Gold bugs were bugged by what happened today (Friday); gold and silver were whacked again. But the precious metals still look good. Nothing really changed in my gold and its step sum chart, both are still rising nicely.

Silver looks good too, just a tad below its BEV -30% line, and on track to move to higher prices.

What can I say; the entire global financial system is out-of-whack. So what are we to do? Well Doctor Bernanke would tell you to take two aspirins in the morning as you buy more of those cheap financial stocks, AAA rated US Treasuries, and stop bothering him with those pesky phone calls asking him when to sell! But I expect those words-of-wisdom will prove to be yet another example of the past bad advice he is becoming famous for. Personally I recommend listening closely to the good doctor, and then do the opposite; like buying and hold gold and silver, and dumping the financials and Treasury Debt.

Mark J. Lundeen
Mlundeen2@Comcast.net
03 March 2012

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Greek Credit Default Swaps

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