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Ban Credit Default Swaps? These Corporate Bankruptcies Show We Should

Martin Hutchinson — Thu, 23 Apr 2009 14:15:12 +0000

For frustrated investors looking to justify the ban of credit default swaps (CDS), look no further than last week’s corporate bankruptcies of Canadian newsprint producer AbitibiBowater Inc. (ABWTQ) and U.S. shopping center developer General Growth Properties Inc. (GGP).

In both of these cases, credit default swaps became an actual bankruptcy catalyst – for the first time ever.

In the lead-up to both bankruptcies, the lenders who had debt outstanding – who would have the right to vote on any reorganization – had hedged their debt through credit default swaps and so stood to benefit from the company’s bankruptcy. That made it very difficult for both companies to get the majorities they needed for debt reorganization, making bankruptcy inevitable.

The CDS holders were in the position of seeing a 1929-vintage stockbroker balanced on a window ledge, and yelling “Jump, jump” – while simultaneously taking bets on the result.

In the AbitibiBowater bankruptcy case, holders of credit default swaps played two key roles:

They were spectators and potential litigants.
And they were the generator of lawsuits.

Let’s consider the first point.

When AbitibiBowater missed a bond payment on March 20, there were a lot of CDS derivatives outstanding that were close to maturity. Holders of these securities wanted to have AbitibiBowater immediately declared in default so that they could collect – a delay would allow their credit default swaps to expire.

However, non-payment of bond obligations generally does not become an actual “default” for several days (because the company is given a few days to come up with the money). Moreover, AbitibiBowater obtained a court order allowing the bond payments to be suspended while the company completed its debt restructuring. Thus, the CDS holders (to a value of about $500 million) were out of luck.

Or were they?
An International Swaps and Derivatives Association (ISDA) ruling on March 28 allowed CDS holders (as of March 20) to claim payment through a cash-auction system, as if a default had actually occurred.

The second role that CDS holders played truly was analogous to sadistic spectators placing bets at a suicide. Bowater (which had merged with Abitibi in an over-leveraged deal just two years ago) wanted to exchange its 9% bonds in order to improve its cash flow and to remove the likelihood of bankruptcy. To do this, it needed 97% acceptance from holders of bonds maturing in 2009 and 2010. The company was only able to get a 54% acceptance – largely because many bondholders also held credit default swaps, and so would actually benefit, rather than lose, from a Bowater bankruptcy.

General Growth, a shopping center developer with $27.3 billion in debt (real money even these days) – making it the largest default in U.S. real estate history – demonstrated the darkening cloud that’s hovering over the U.S. commercial real estate market. It also underscored the risks of being involved with credit default swaps.

General Growth’s mortgage debt had been securitized into mortgage-backed bonds, many holders of which had also bought credit default swaps, so debt restructuring proved impossible. Credit default swaps on General Growth’s vaunted Rouse unit were valued by auction on April 15, and were deemed to be worth 71% of par, so investors in them received $710,000 for each $1 million of CDS they held – a nice reward for voting “no” to a corporate restructuring.

Guess what? If busted insurance giant American International Group Inc. (AIG) was the writer of any of the credit default swaps on either AbitibiBowater or General Growth, we as taxpayers have paid the profits of the guys who forced those companies into bankruptcy.

A comforting thought, isn’t it?

The credit-default-swap rap sheet is becoming quite long. In the AIG case, CDS securities allowed an insurance company to write more than $200 billion worth of contracts, booking the premiums as income and reserving nothing against the potential losses, thus bankrupting itself at taxpayer expense.

Credit default swaps then allowed major banks – such as Goldman Sachs Group Inc. (GS) – to collect large sums through their holdings of AIG CDS contracts, while themselves having protection against an AIG bankruptcy, thus double-dipping at the expense of American taxpayers.

These big financial institutions have now facilitated the largest real estate bankruptcy in U.S. history – as well as the bankruptcy of the world’s largest supplier of newsprint – by preventing creditors from agreeing to restructuring plans.

These same perpetrators were an accessory before the fact in the Lehman Brothers Holdings Inc. (LEHMQ) bankruptcy, because they provided the best-leveraged and highest-volume method by which hedge funds could benefit from a Lehman default – the CDS markets had much bigger volume than the stock-options markets, and better leverage and less risk than a direct short sale of Lehman’s stock. By buying credit default swaps and shorting Lehman stock, hedge funds caused a classic “run” on that unfortunate institution that would probably not have occurred otherwise – or even been possible.

In each of these cases, credit default swaps have imposed costs on taxpayers, on the U.S. and Canadian economies, and on society in general. And these costs are outside the terms of their own contracts.

If credit default swaps were just Wall Street gamblers’ playthings – used to “hedge” exposures and provide gaming opportunities for hedge funds – the securities might have some modest net social utility.

However, in the cases we’ve highlighted, the CDS market has proved to be a means of extracting rents from taxpayers and other outsiders. If AIG had been allowed to go bankrupt properly – causing huge losses to banks, investment banks and hedge funds – credit default swaps might well have died a natural death.

The rescue of AIG provided them with artificial life support – thanks to a U.S. taxpayer subsidy of more than $150 billion – a fact that has perpetuated their existence.

In terms of regulation, a moderate step would be to allow the purchase of CDS securities only by those with an “insurable interest” in a particular debt. Further provisions could be written, providing that voting rights on a debt were transferred as credit default swaps were written on that liability. You could even force CDS securities to be weighted 100% in bank risk capital calculations, as if they were direct loans.

However, even a CDS purchase to offload a direct credit risk can equally well be undertaken by a simple sale of the debt, which would at the same time transfer its voting rights in any bankruptcy.

Since hedging and transfer of a debt position is perfectly possible without the existence of credit default swaps, what valid economic purpose do they serve?

I’m one of the biggest free-marketers on the planet, but these things aren’t the free market, they only work because of bank regulation and the “too big to fail” doctrine. When I ran a derivatives desk in the 1980s, we looked at the possibility of credit default swaps – it was an obvious derivatives application – but we decided that they were impossible to hedge and their payout in default was too uncertain for them to be sound financial instruments.

We were right. The market for CDS securities only mushroomed in the late 1990s because – by that stage in the long economic bubble – bankers had stopped worrying about long-term soundness if it meant they could receive larger short-term bonuses.

Let’s ban them. Wall Street will scream about the loss of income, but that loss will be trivial compared to the amounts taxpayers have already paid to bail out Wall Street from its mistakes. The modest economic benefits of credit default swaps are dwarfed by the costs and distortions they impose.

Taxpayers have rights, too.

[Editor's Note: When Slate magazine recently set out to identify the stock-market guru who most correctly predicted the stock-market decline that accompanied the current financial crisis, the respected online publication concluded it was Martin Hutchinson, a veteran international investment banker who is one of Money Morning's top forecasters.

It was no surprise to our readers: After all, Hutchinson warned investors about the evils of credit default swaps six months before the complex derivatives did in insurer American International Group Inc. Then last fall, Hutchinson "called" the market bottom.

Now Hutchinson has developed a strategy for investors to invest their way to "Permanent Wealth" using high-yielding dividend stocks. Indeed, he's currently detailing a strategy that will enable investors to make $4,201 in cash in just 12 days. Just click here to find out about this strategy - or Hutchinson's new service, The Permanent Wealth Investor.]

Ban Credit Default Swaps? These Corporate Bankruptcies Show We Should

Corporate Bankruptcies Will be a Key Investor Concern in the New Year

Martin Hutchinson — Wed, 07 Jan 2009 16:15:11 +0000

Investors are breathing a sigh of relief that 2008 is over, but they shouldn’t get too comfortable. After all, with a worldwide recession under way, investors can expect acceleration in corporate bankruptcies in 2009.

But the question is – which ones?

In the financial services sector, 2008 was a year of spectacular failures:

Bear Stearns Cos. and Merrill Lynch & Co. Inc. were absorbed by JP Morgan Chase & Co. (JPM) and Bank of America (BAC), respectively.
Lehman Brothers Holdings Inc. (OTC: LEHMQ) filed for bankruptcy protection.
And financial-sector giants American International Group Inc. (AIG) and Citigroup Inc. (C) were both bailed out a vast expense to taxpayers.

If at the start of 2008 I’d written that the entire New York investment banking business would disappear during the year, you’d have thought me a madman. But it has. The two houses still standing, Goldman Sachs Group Inc. (GS) and Morgan Stanley (MS), are both now officially conventional banks, with lower leverage ratios and a changing business mix.

In the New Year, we’ll see less turbulence in financial services than in 2008, if only because it would be almost impossible for it to have more. The dangerous process of de-leveraging becomes less dangerous as leverage itself is reduced, and the capital injections from the Troubled Asset Relief Program (TARP) into the major U.S. banks have hastened their recovery. Solid banks such as Wells Fargo & Co. (WFC), and PNC Financial Services (PNC) are likely to do quite well, gaining market share at the expense of their weaker brethren.

Indeed, Wells and PNC each completed major buyout deals right as 2008 came to a close.

This year, however, will be the one in which banks that have truly done a poor job will be separated out from those who merely made the obvious mistakes of the boom and just need time and some extra capital to work through their problems.

Citigroup, for example, was at the beginning of 2008 a pretty obvious example of financial-sector “roadkill.” A messy conglomerate of banking, investment banking and insurance that had been put together but never properly integrated, Citi had been at the forefront of every major financial disaster in the last 30 years and was not about to miss this one. The fact is that only weeks after receiving a $25 billion capital injection from the TARP, Citi was back in trouble again, this time requiring not only more capital, but a $300 billion guarantee of its liabilities. That’s a pretty good indicator that in a free market, Citi would have slid into corporate bankruptcy and liquidation.

Obviously, if the government chooses to keep Citi afloat, U.S. taxpayers, as a group, are (just) rich enough to make that happen. But a sensible government will eventually realize that these expensive rescues are pointless. The financial services business – once an economic mainstay – is declining in importance in the U.S. economy, and is probably half its relative size compared to its historic levels from the 1970s. In such an environment, capacity needs to be lost and Citi is the capacity most obviously surplus.

If Citi is propped up by the taxpayer, some other bank may be forced into bankruptcy, instead: My bet would be Bank of America, which made a very foolish acquisition in Countrywide Financial Corp., at the beginning of 2008 and a very dangerous one (because of its size and over-leverage) in Merrill Lynch right at the end of the year.

Countrywide was an enthusiastic participant in the worst excesses of the housing bubble, and hence will have a correspondingly large share of its detritus, while Merrill Lynch itself made what turned out to be a major misstep when it bought a major subprime mortgage lender, First Franklin, at the absolute peak of the bubble in 2006. Merrill had actually prided itself on its aggression in the housing finance business, but ended up having to shut down portions of First Franklin.

Aside from financial services, 2008’s major bailout was in the automobile sector. As is well known, all three major U.S. automakers – General Motors Corp. (GM), Ford Motor Co. (F) and Chrysler LLC – are in financial trouble and could be pushed over the edge by a couple of bad quarters. Given that the government would hate to see a major U.S. manufacturing sector disappear – especially one with the high profile that the car business has – and that the sums of money involved are smaller than in the banking business, I would not expect the automobile companies to be liquidated.

General Motors has world-class engineering and research capabilities that remain of huge value, and is becoming a bigger player in Asia, while Ford is in better financial shape than its competitors and also has good international operations and sufficient scale for its current focused strategy. On the other hand, it’s clear that both companies need to get out from under their past pension obligations, as well as their United Auto Workers Union (UAW) contracts, in order to compete against lower-cost competitors, both internationally and domestically (where a lot of the foreign carmakers now manufacture).

So, either a UAW agreement combined with a government assumption of most pension and healthcare obligations or a Chapter 11 filing (which would void the UAW and pension contracts) is needed. My bet would be on a “prepackaged” Chapter 11 filing – not a disaster for the companies, but I’d still avoid the shares.

As for Chrysler, it is too small to compete properly, has no international presence, and is owned by an overstretched private equity outfit. So hasta la vista, Chrysler!

Another area that’s seen its share of bankruptcies is retailing: Circuit City Stores Inc. (OTC: CCTYQ), Linens n’ Things Inc., Mervyn’s LLC and Sharper Image Corp. (OTC: SHRPQ) were among the biggest names to file in 2008.

That’s not surprising: Consumer spending is down – even in nominal terms – and needs to fall further, as the U.S. consumer rebuilds his savings rate from 2007’s pathetic 0.7% to the 6% to 8% range that was more the norm in the pre-bubble years. The recession will inevitably push more retail chains over the edge, with the highest casualty rate being among high-end and specialty retailers: Saks Inc. (SKS), for example, is taking losses and could be in trouble.

At the bottom end, as a recent Money Morning “Buy, Sell or Hold” feature detailed, Wal-Mart Stores Inc. (WMT) will probably continue to do well as middle class consumers find their budgets pinched and decide to restrict their spending to the land of “everyday low prices.”

If the recession is even longer and deeper than it’s already been, two other victims of middle-class spending cutbacks could be Target Corp. (TGT), which lacks Wal-Mart’s purchasing ability and whose prices are significantly higher than Wal-Mart’s, and The Home Depot Inc. (HD), which over-expanded during the housing boom, replacing traditional hardware stores, and which lacks the service capability to facilitate recession-resistant D-I-Y (do-it yourself) projects.

Producers of luxury goods, as well as retailers, may find themselves in trouble.

Just this Monday, china-maker Waterford Wedgwood PLC, filed for bankruptcy. The Dublin-based company, with more than 200 years of history, was a victim of social change and the move to less formality as much as it was to the global recession.

Like high-end retailers, luxury-goods producers will suffer from a massive decline in their customers’ purchasing power, as Wall Street bonuses disappear and redundancies soar, Middle Eastern oil sheiks cut back amid declining oil prices and the Russian mafia is forced to ask Prime Minister Vladimir Putin for bailouts. Many luxury goods producers are quite small and private, so their disappearance will not affect investors, but even such a giant as LVMH Moet Hennessey Louis Vuitton (OTC: LVMHF) will not find itself immune to the global downturn, and may be in trouble if that financial malaise remains in place for a long stretch.

It’s a rough tough world out there. As investors, corporate bankruptcy should be our No. 1 risk concern in 2009.

Source: Corporate Bankruptcies Will be a Key Investor Concern in the New Year

Revenge of the Poor!

Bill Bonner — Fri, 12 Dec 2008 15:04:00 +0000

The markets are looking over the worst spending slump in 60 years…that planet’s first Worldwide Bailout… And look at that – we’re back to the ‘deficits don’t matter’ stance…the more the Fed tries to fix the problem, the worse it gets… Savers are losing a couple of percent per year to inflation…investors are losing money in every asset class…and more!

The rally seems to be continuing. The Dow rose 70 points yesterday. Oil slid up to $44. Commodities went up too. And gold shot up $34 – to $808.

The markets must be “looking ahead”…right over the worst economic news in 60 years.

It’s the “worst spending slump since ‘42,” says a headline at Bloomberg. In ‘42, the United States was at war with Japan and Germany. And it looked for a while as though we might lose! No wonder spending collapsed…the economy was shifting to a ‘war footing.’

And now spending is collapsing again. And this time the economy is again shifting to a war footing – a war against deflation. Why fight deflation? Doesn’t it lower the cost of living? Doesn’t it make it easier for poor people to eat?

Well…yes…maybe. Deflation lowers prices. Deflation favors the poor…at least in the early stages.

The number of corporate bankruptcies is expected to soar next year. According to the Financial Times’ tally, more than 300,000 businesses will go bust in America, Britain, Western Europe and Japan. Who owned those businesses? Not the poor.

You can do the math as well as we can, dear reader. Imagine that each bankruptcy puts 100 people out of work. Let’s see, that 30 million people without jobs. The middle-class unemployed draw down their savings and begin spending their pensions; the poor will have to continue to live hand to mouth. Advantage: the poor again.

Yes, it’s the planet’s first Worldwide Depression. And the planet’s first Worldwide Bailout. Now the meek are inheriting the world. The downtrodden are getting up off the ground.

The latest news from India tells us that the government is pumping $4 billion into the economy to try to pep it up. $4 billion may not be much to you…we’re now used to trillion-dollar bailouts…but India is a poor country. A billion still means something.

The latest measure brings to $60 billion the total India has committed to the fight against the slump. Even that, say critics, will not be enough. But India is not in such a bad slump – at least, not yet. GDP is moving ahead at a 7% annual rate. Indians may be poor…but they have little debt…and they’re getting less poor every day.

Our Indian colleague, Ajit Dayal, says India is in a good position:

“Our financial sector never went in for sub-prime debt. There is very little consumer credit in India. Inflation is going down; it’s expected to be only about 1% next year. The economy is still growing fast. We have a huge domestic demand; we aren’t as reliant on exports to the USA as China is. And our stocks are very cheap. You can buy companies in India now for less than the cash they have in the bank…and at 2…3…5 times earnings. There is even an oil company paying a 10% dividend. India will be just fine. And as soon as foreign investors realize it, Indian stocks will rise again.”

Meanwhile, in the U.S.A., Mr. Obama hints at what is ahead. It will get worse before it gets better, he keeps saying. And if it doesn’t get worse on its own…he’ll help make it worse!

The Financial Times reports:

“While noting the US budget deficit might already surpass $1,000bn, Mr. Obama added:

“‘We understand that we’ve got to provide a blood infusion to the patient right now to make sure that the patient is stabilized. And that means that we can’t worry about the deficit.’”

So you see, Republicans…Democrats…deficits still don’t matter. Even though deficits are the root cause of the present predicament, the Obama Administration is planning to give us more of them. Oh dear reader…this is going to be Hell to live through…but it’s going to be fun to watch.

We’re going to see more transfusions than in a Baltimore emergency room on Saturday night…there’s going to be blood all over the place. Deficits will hit more than $2 trillion before this is over.

And what else? The price of gold will probably go to $2,000…so take advantage of the low price now, while you can. In fact, you can still get gold for just a penny per ounce…see here.

Yes…it’s going to be fun…

Will all these bailouts work? Of course not. The government has no real savings. What can it do? Either borrow…or just print up the money the way they do in Zimbabwe. Either way, all it is doing is shifting resources away from people who earned it…and towards people who didn’t.

It’s a hidden tax that people don’t complain about…because they don’t understand it. Who will be the recipients? The insiders, of course…but also the outsiders. That is, while the elites will skim a good deal of the loot for themselves, quite a lot of it will go to “the poor.” Why? Well, two reasons – one legitimate…the other corrupt. Since the poor have no balance sheets to repair, the feds can be sure that if they give the poor money it will go right back into the economy. More importantly, the poor vote. And you can buy more poor votes for less money than you can buy rich ones.

So you see, dear reader, the poor are coming out way ahead. Everyone else is losing money…and they had nothing to lose.

So far, the bailouts have worked like a straightjacket. The more the feds fight against the correction, the tighter the straightjacket binds…restricting their movement even further. Already, they’ve committed more than $10 trillion in various bailout measures…and the more they try to fix the problem, the worse the problem gets.

They’ve not got much wiggle room left. As for monetary policy, the Fed has used all but 100 of its basis points. A couple more rate cuts and the key Fed rate will be zero.

Could it go below zero? Not really. But the feds could impose a penalty on cash deposits…as Switzerland once did. Or…they could simply inflate the currency so people will want to get rid of it as quickly as possible. Either way, people who save their money for a rainy day will lose money.

Of course, they’re losing money already. The real rate on savings is negative… the inflation rate is about 3% or 4% while the return from money market funds is zilch. Well, actually, zilch would be an improvement. Savers are losing a couple of percent per year – just to inflation.

Who saved money? Not the poor.

But even the savers count themselves among the lucky ones. Stocks are down about 50% worldwide. Mutual funds have gotten hammered. Hedge funds have been clipped for big losses. Leading American brand-name companies are down 50% to 80%. Middle-class Americans have seen their 401(k)s cut in half…while their houses have lost 20% of their value, and are still going down.

The poor have none of these things. In fact, the poor have no financial assets at all.

Remember the advice financial planners used to hand out: put your money into a balanced portfolio of various asset classes. One might go down…but they won’t all go down.

Oh yeah? Almost every asset class has been hit hard…

growth stocks…retailers…technology…energy…emerging markets…

And not just stocks, suppose you put your money into one of those nifty partnerships with swaps and SIVs and other investments the experts said were as safe a T-bonds? You’d be lucky to have anything left at all.

And commodities? Weren’t they supposed to be so scarce that they couldn’t go down? Even we cynics at The Daily Reckoning were almost convinced. We knew oil was too expensive at $147…but we thought it was fairly priced at $90. Now, it’s less than half that.

Just goes to show…you never know. You know that what must happen, will happen. But you never know how much it will happen…or when.

Now investors are losing money in EVERY ASSET CLASS – including cash. Is this a first? Maybe.

But now we can more fully appreciate the elegant wisdom and justice of the free market system. Mr. Market may be a hanging judge…but at least he’s fair.

The great asset bubble seemed to prove out the old expression “the rich get richer and the poor get poorer.” But it was all a mirage, caused by a bubble in credit. The rich were getting richer…but only on paper. And now paper of all sorts is going up in smoke. The “rich” have lost a quarter to a half of their wealth. The poor have lost relatively little. Now, the rich get poorer. And the poor? Well, they will always be with us. But being poor is not so bad. Many of the middle-class lumpenhouseholders, for example, are “upside down” on their mortgages. They’re below zero, in other words. The poor – with nothing – are ahead of them.

Who would have thought?

*** The English press has focused on the personal side of the downturn.

Turns out, a lot of women who married rich men in the financial industry were in it just for the money. “Toxic wives,” at least, that’s what the press calls them.

A recent article mentioned a man who had turned to his wife a year ago and asked:

“Would you still love me if I lost all my money?”

“F*** no,” was the reply.

The banker thought his wife was just being playful. But when he lost his job in The City (London’s answer to Wall Street) she moved out…taking what little money he had left.

The commentators despise these women; they married men only for the money. But what’s wrong with that? Money was all these men had. Besides, anyone who marries for money earns it.

Meanwhile, the Financial Times reports on another phenomenon, said to be linked to the financial crisis. Men and women – usually married – are turning to “adultery websites” for comfort. One is called “Illicit Encounters” and features people who appear to be professionals – many from the financial industry. They describe themselves as investment bankers or stock analysts, go by handles such as “Alpha 123″ or “CityGent”, and say they are looking for love, romance, or just casual sex. The website charges men 119 pounds. “Women go free.”

Source: Revenge of the Poor!