James Howard Kuntsler (Whiskey & Gunpowder):

“While Dubai is not big enough to set off financial repercussions outside the Middle East, the main fear is that investors could flee risky markets all at once in search of safer havens for their money.” — The NYT, Vikas Bajaj and Graham Bowley, reporting.

Apart from the stark self-contradiction in this quote from The New York Times, you have to love the fatuous ‘it’s all good’ self-assurance where global banking is concerned. No problemo y’all! A mere overdraft incident, a cash-flow hiccup… and yet “the main fear” [among whom?] is that investors [where and in what? Like, everywhere?] could flee risky markets all at once in search of safer havens for their money [WTF?]. Gosh, well, as long as they don’t flee the New York Stock Exchange, the Hang Seng, the FTSE…. And, hey, do you suppose anybody bought any credit default swap “insurance” on the deals that financed scores and scores of super-giant condominium skyscrapers and hotels amounting to the greatest spec construction folly in the history of the world?

Snapshots of the stupid ****ing work-in-progress have been circulating around the Internet for five years, the disbelief was so monumental. I confess, when I first saw the Palm Island I was impressed at what a superb air strike target it presented. And then, when the real estate assemblage of artificial islands arranged like a map-of-the-world came along, I could only imagine the megalomaniacal glee rising in the throat of a jet bomber pilot (nationality unspecified) as he closed in on it.

Whom the gods would punish, they first make completely crazy. That includes us, here in the USA, by the way, but pound-for-pound Dubai is the current champeen. The monstrosity they built in their waterless convection-oven of a city-state makes Las Vegas look like a mere strip mall in comparison. Throw in a few other affronts to nature, such as an indoor ski “mountain,” a beach cooled by an under-the-sand refrigerated pipe network, golf courses that have to be hosed down with acre-feet of desalinated sea-water, and forget about “the gods” — one begins to see the monotheistic hand of “Old Scratch” himself working the levers of the construction cranes out there.

Frankly, I have no idea whether the Dubai fiasco will send seismic ripples thundering through a global banking establishment that is already crippled in more ways than you can count. But it does remind those in thrall to the dazzlement of “green shoots” that debt comes a’creeping, and runs so far, deep, and wide through the broken system of mutual assurances constituting international finance, that Ben Bernanke and his counterparts in central banks ’round the world could drop helicopter loads of paper cash on every rooftop, intersection, parking lot, field, forest, and camel raceway and never make a dent in the fatal web of false obligations we have woven for ourselves.

Click here for the rest of Mr. Kunstler’s analysis at Whiskey and Gunpowder.

• Microsoft Corp.’s (MSFT) quarterly profit rose 2% from a year ago, the company said yesterday (Thursday) in a statement. The world’s largest software maker earned $4.37 billion, or 48 cents per share, in the quarter ended Sept. 30. Sales rose 9% to $15.1 billion.

• Goldman Sachs Group Inc. (GS) is cutting 3,200 jobs, or 10% of its work force, as the firm struggles with the credit crisis and transitions into a holding company. The cuts add to more than 130,000 jobs eliminated in the financial industry since mid-2007, topping the 83,000 lost after the Internet bubble burst in 2001, Bloomberg reported.

• The Dow Chemical Co. (DOW) yesterday (Thursday) reported a 6% rise in third-quarter profit. The company reported earnings of $428 million, or 46 cents per share, up from $403 million, or 42 cents per share, a year ago. Sales rose 13% to $15.4 billion.

• Sony Corp. (ADR: SNE), the Japanese consumer electronics giant, announced (Thursday) that profits would be markedly weaker for fiscal year 2008. Sony predicted earnings of $1.5 billion (150 billion yen), down from an earlier July forecast of $2.4 billion (240 billion yen), The Washington Post reported.

• An auction to set the value of Washington Mutual Inc. (OTC: WAMUQ) debt was held yesterday (Thursday). Markit and Creditex, auction administrators, set the debt cost of failed bank Washington Mutual at 57 cents on the dollar. Sellers of credit default swap protection must pay 43 cents to counterparties, MarketWatch reported.

• Crude oil gained $1.09, or 1.6%, to settle at $67.84 yesterday (Thursday) in anticipation of the Organization of Petroleum Exporting Countries (OPEC) meeting today (Friday). “If OPEC makes a cut of 1 to 2 million barrels tomorrow, prices should firm up and move higher in the short term,” Gene McGillian, an analyst at Tradition Energy in Stamford, Conn., told Bloomberg News. “Unless there is something huge announced, the market will eventually start moving lower again because of the weak economy.”

Source: Global Investing Roundups Friday, October 24th, 2008

The first true credit default swap was carried out as late as 1995, although various types of credit protection derivatives existed earlier. Its structure is similar to an ordinary interest rate or currency swap transaction, and the CDS market is covered by the International Swaps and Derivatives Association Inc.

Under a CDS, a bank originates loan to a company. A second bank (or other financial institution) can agree to cover the credit risk for the loan, by agreeing to make payment to originating bank if the company defaults on the original loan. The originating bank pays a small insurance premium to the second bank for assuming the risk of the loan.

Typically, payments under a CDS would only be triggered by the company’s failure to pay interest or principal on its debts due to bankruptcy or some other severe liquidity issue. But there are a host of intermediate or special cases that will doubtless provoke lawsuits when something goes wrong (CDS being a new market, it is by no means “recession-proof”).

Credit default swaps were sold to the world as hedging transactions. Investors were told that they were simply transfers of risk, so that banks that made loans could transfer credit risks to insurance companies, which did not make loans directly, or to foreign banks that could not easily make loans in the U.S. market.

And if an originating bank sells its loan exposure only once, and sells it to a financial firm of undoubtedly solid credit, the CDS does indeed act as a hedge for the originating bank; it transfers the company’s credit risk from the bank to the financial firm that bought its CDS.

But the product did not work as advertised.

Enter the Traders

Salesmen and traders took over, and expanded the volume far beyond what was required for hedging.

After all, bonuses depend on the volume of business. Therefore, bank traders sold the credit risk of a loan not just once, but as many as 10 times. And they sold it not to solid banks and insurance companies, but to three solid banks, one solid insurance company, three dodgy brokers and three hedge funds. Then the traders went out and sold other CDS products that were not even related to actual loans on the books, but to imaginary indices of credit quality in the “widget” industry.

The credit risk of the system was hugely multiplied.

Instead of one $10 million credit risk loan, there are now ten $10 million credit risks on just one loan.

• Three on solid banks – but will they stay solid?
• One on a solid insurance company – probably OK.
• Three on dodgy brokers – who knows?
• And three on hedge funds – probably not OK in a real downturn.

The total credit risk in the system has been increased from the original $10 million loan to somewhere between $160 million to 200 million, depending on whether the banks and insurance company are financially solid.

Of course, a lot of those credit risks offset each other, so that if the company that took the loan goes bust, the only risk to the bank that sold all those CDS is to the profits it expected to make. But since it probably hedged those positions against others, if the company does go bust, and dodgy brokers and hedge funds stop paying up, the total losses in the system from that company’s credit risk are likely to be a substantial multiple of the original $10 million loan.

But please don’t think I was exaggerating when I said as many as 10 credit default swaps got sold for each loan.

The U.S. commercial loan market is worth about $5 trillion, yet the volume of CDS outstanding is currently no less than $50 trillion. In other words, a huge number of traders, salesmen and quants have been making money off this product, without any real “hedging” rationale at all.

And it all worked fine while the volume of defaults remained low, which is why the market expanded from $2 trillion to $50 trillion between 2000 and 2007.