Do you remember Lloyds of London? It used to be the world’s biggest insurance underwriter. The way it worked was that rich individuals were allowed to keep all their money invested in their favorite stocks and shares, but they could also earn a second income from those assets by pledging that same wealth to underwrite commercial insurance risks, which were sliced and diced by syndicates on behalf of their members.

Unfortunately, when a series of vicious insurance losses hit the world’s insurance market through the early ’90s, many Lloyds members lost absolutely everything - houses, furniture and indeed their lives. Many of today’s professional money managers engage in a similar practice when they sell credit default swaps (CDS).

CDSs, CDOs and all the other credit derivatives that populate the global financial markets present a new and uncertain risk for investors. Let’s dig a little deeper…

CDOs, as we explained in last Friday’s edition of the Rude Awakening, are new-fangled credit derivatives - i.e. they are bond-like instruments that are derived from pools of loans, usually mortgages. Through the wizardry of modern financial engineering, a pool of sub-prime mortgages, for example, can become an array of CDOs, some rated as high as AAA, others rated much lower. Industry insiders sometimes refer to the lower-rated CDOs as “toxic waste.”…

Institutional investors have been gobbling up these high-yielding - but very risky - CDOs because they are able to buy default insurance - otherwise known as a credit default swap (CDS).

For example, the buyer of a particular CDO could simultaneously buy a CDS to protect against a default. The investor would, effectively, pay an insurance premium to another investment institution for underwriting the risk of the underlying home-loans defaulting. Apart from a bit of legal drafting, that’s all there is to a Credit Default Swap. In return for a cash payment, you swap the risk of default.

These insurance premiums, paid to the underwriter of the CDS, appear to the receiver as income - just like the insurance premiums that any insurance company would receive. You are being paid for accepting risk, not for lending money.

So you see, the investment bankers have been very clever. They have said there are two components in a bond-interest payment: a fee for the use of your money, and a fee for the risk of default. The CDS simply separates out the [fee] for the risk of default.

The investment bank can have still more fun with this. Just like the boring mortgage streams that we started with, these CDS streams can be aggregated into a pool…then divided into tranches with different risk profiles…producing the magic of higher credit ratings for lower-risk tranches…plus concentrated risk in new toxic waste.

If you can get a credit rating agency to assess the tranches you have created, then you have something that looks like a CDO - and smells like a CDO - but which is not now based on cash flows deriving from borrowed money. Instead, it is based on cash flows deriving exclusively from insurance premiums that are paid to cover the risk of mortgage default.

That’s how CDSs get packaged into what is known as a “synthetic CDO,” and the investment banks can sell them for what appear to be fantastic yields. It’s a really neat deal…for the investment banks, which are selling to the highest bidder the right to receive their mortgage default insurance premiums in exchange for assuming the risks of default - so the buyer is just another “investment landfill”. He ends up with what’s called a “contingent liability.”

Why would any investment fund possibly fall for this scheme? The modern fund manager has a powerful short-term incentive to get a strong performance out of your invested savings. If he gets 2% more than the next guy he is a genius, and he will get more money under his management and much larger performance fees. As long as defaults occur rarely, synthetic CDOs can provide a pretty neat deal for the investors. They earn a steady income stream, simply by promising to stump up if there’s a default.

So you can see now how through the use of synthetic CDOs, fund managers can underwrite credit default risk and increase their income accordingly, without outlaying any fund capital. Importantly, however, they are placing their fund capital at risk. Your fund manager is a genius while there are no claims. But if it goes wrong, your fund gets hammered.

But the CDO story does not end here…

It was not long before the investment banking industry had a “Eureka” moment…They started insuring against the default of securities they didn’t even own! It’s like noticing your friend is looking a bit ragged and taking out insurance on his life for your benefit, without him having anything to do with it. And as long as there is demand for “easy income,” there’s no limit to how many of [CDS, the investment banks may create.]

When Delphi Corp (DPHIQ), a large motor parts spin-off from General Motors (GM) , got into serious trouble last year, its bonds fell into default. Incredibly, more than 10 times the nominal value of its bonds were then claimed from investment institution underwriters, by bankers who had insured against the default of bonds they didn’t own by issuing Delphi CDSs.

This isolated incident suggests that the mushrooming growth of credit-derivative issuance imparts an unknown and untested threat to the global financial system….

Long Term Capital Management failed in 1998. It was the last truly serious financial collapse which threatened the U.S. financial system. When LTCM went under, the bail-out fund required was $3.65 billion. The [LTCM] fund itself was leveraged to about $125 billion of assets…

Back in 1998 LTCM was plowing a lonely furrow. Its investment view was something to do with Russian bonds and the Japanese Yen. It was off the main investment spectrum, and there were few copy-cats putting the same market view into action in the same way.

That is where things are very different this time…Many banks and funds are involved…This makes the size of the problem potentially much larger, and of much greater risk to the whole financial system.

How large?…Depending upon who’s counting, the world’s investors now hold somewhere around $1 trillion worth of credit derivatives, at market value. But since the notional value of these arcane financial instruments exceeds $25 trillion, no one really knows how large the potential losses could become during a panic.

Now you can see the difference in scale between LTCM and the subprime bust. This may be 20 times worse than LTCM. And it’s getting worse - daily.

At a time like this, we should not underestimate the skill of people like Ben Bernanke at the US Federal Reserve in underpinning the financial system. They have been remarkably effective at organizing the lifeboats over many years and many crises….[But] Here at BullionVault we think the Bernankes of this world will one day fail.

The result will be a credit squeeze. Bond issues will be pulled, bank loans recalled, and business activity will sharply decline for lack of funding. The first two of these have certainly started - with a rash of failed issues at the end of June. Will these risks be contained? We don’t know…

Clearly we’re biased against excessive leverage, and against too much financial ingenuity, too. That’s why we’re in the physical gold bullion business. We believe that real physical gold is a sensible insurance against today’s increasingly weird financial system. It has been astonishingly reliable in that role in the past.

But this time, who knows?

Source: Investment Landfill, Revisited