Taipan Daily editor Justice Litle says investors have every reason to fear the ticking credit default swap (CDS) “time bomb.” Why? 1) Because these obscure instruments have a notional value of up to $60 trillion. 2) They aren’t regulated on any exchange. 3) They are now a back-office nightmare: Half of all CDS trades were made through instant messenger!

This from Justice:

That Credit Default Swap market? The one with a notional value of forty to sixty trillion? No one was regulating it, and no one really understood the trades being made.

Think about that for a second. A wild west trading market with a notional value bigger than the net worth of the entire global economy was, to whit, left completely bereft of adult supervision.

When you buy, say, a futures contract or a stock options contract, you can know it’s traded on a central regulated exchange. You can track the paper trail and confirm who your counterparty is if need be. Just as important, your counterparty also has to pass muster with the exchange in question; he (or she or it) has to have enough money in a verified account before trading with you in the first place.

Not so with Credit Default Swaps. These “CDS” trades – tens of trillions worth – aren’t traceable back to any exchange. They are 100% “over the counter,” i.e. “swim at your own risk.”

Because there was no supervision of the Credit Default Swap market, you could have done a hundred-million-dollar CDS deal with a hedge fund in Antigua if you so chose. Heck, you could have put on a seven figure trade with your Uncle Fred. Or the hairdresser down the street. Or your neighbor’s cat.

Nobody was paying attention, so the solvency of the counterparty (i.e., their ability to pay up) didn’t really matter… until it all went to hell.

Thus, not only did we have a bunch of high-paid idiots making leveraged bets on the assumption home prices wouldn’t fall… we had them making these bets in completely unstructured fashion, with no real due diligence as to whom was on the other side (or whether they could pay). 

Back Office Nightmare

So imagine you run the back office for a reputable banking house. You’ve got a pile of boxes nine feet high, all of them stuffed to overflowing with paper documents. This paper mountain represents all the CDS trades – hundreds of billions of dollars worth – that your in-house trading department made in the past two years.

Half these trades were made through instant messenger. Some of the printouts and scribbles you can’t even read. You don’t have a prayer of sorting out who traded what or with whom… not without a few months of digging and sorting anyway. You don’t know how many of your trading counterparties are out of business, let alone solvent.

As if that weren’t enough, you don’t even know if your own trading department is on the hook for tens of billions… or whether tens of billions are still owed to you!

Can you imagine being the CFO in a situation like this?

Where do we stand, Johnson?

Well sir, we’re either in mighty fine shape or we’re bankrupt. We’ll know which in about three months time, once we get this nine-foot-high pile of papers sorted out…

Is it any wonder everything came screeching to a halt?

Epic Dumbness

I can hardly believe the stupidity, the sheer dumbness, of this whole mess. Just thinking about it makes me want to punch Greenspan in the face – and Hank Paulson too. (Greenspan was a huge cheerleader for deregulation throughout his term as Fed Chief. Paulson was instrumental in getting the “big five” exempt from leverage caps back in 2004.)

Like Buffett, Paul Volcker was interviewed on Charlie Rose. Here’s Volcker’s take:

We built an extremely flimsy super-structure. I think the financial markets that we built up are kind of a Potemkin Village. You know, $60 trillion dollars worth of nominal insurance against credits, and they only had $10 trillion in credits! I mean what’s going on here, why did we need $60 trillion worth of protection, because people are trading with each other, speculating in effect, and you know, in trading markets, trying to make some money… and now when people have questions it begins to clog up the system, because all the money he needs – margin requirements, he needs collateral… it’s kind of a dead use of credit, dead use of liquidity to have to be margining all these requirements. And that’s where we are, we’re stuck.

Fear the Time Bomb

Even now – right now, today – there are bank trading departments all over the world still trying to figure out what they own. It’s like having a potential time bomb in your basement… except your basement is so damn cluttered that if a time bomb is down there, you don’t know where it is or how you can get to it.

So this credit freeze-up, in a nutshell, is why the stock market collapsed last week. Not only did banks all over the world pick up huge exposure to falling home prices, they did so in a completely insane way via the Wild West CDS market. When it became clear how widespread the problem was, every bank viewed every other bank as a huge blowup risk.

This filters into the “real” economy because credit is the lifeblood of the real economy. When lending stops, everything stops. Lots of day-to-day businesses rely on credit for mundane things like ordering supplies and making payroll. So when the banks really and truly stop lending – for fear of not knowing who will blow up next – it ultimately grinds everything to a halt.

If the authorities were to truly fail at getting the credit flowing again, it would only be a matter of time before gas stations and grocery stores started shutting down. Without functional credit markets, we’re on the path to the bottled-water-and-bullets scenario. It’s deadly serious stuff.