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

]]> http://www.contrarianprofits.com/articles/ban-credit-default-swaps-these-corporate-bankruptcies-show-we-should/15849/feed 0 http://www.contrarianprofits.com/articles/swapping-out-commodities/2682 http://www.contrarianprofits.com/articles/swapping-out-commodities/2682#comments Sat, 31 May 2008 20:23:50 +0000 John Mauldin http://www.contrarianprofits.com/articles/swapping-out-commodities/2682 The Commodity Futures Trading Commission announced yesterday that they are looking very hard at possibly closing a regulatory loophole that allowed some extremely large commodity index funds to get around position limits.

For those not familiar with the concept of limits, it basically works like this. No trader or fund is allowed to own more than a specific amount of a commodity traded on the futures exchange. This limit varies from commodity to commodity and exchange to exchange. The point is to keep one group from manipulating the price of a commodity, as the Hunts did with silver in the early 80s.

The loophole is one where large investment banks can sell a “swap” for a specific commodity like corn and…

Even more puzzling, capacity utilization is also high at 80.1%, though that is down a half percent from last month. In short words, factories and businesses are running briskly, using 80% of available space and resources. We never hit 100%. An 85% level would be the equivalent of all hands on deck.

As you can see from the chart above, a number like 80.1% typically occurs when the economy is healthy. In the past two recessions, the gray bars on the chart, capacity utilization (hereafter dubbed “caput”) dropped to the 70s.

What could this mean? We know that factory orders for durable goods are down somewhat, which is odd if everyone is producing at close to the normal pace. It should mean more finished goods are ending up on the shelves than in customer’s hands. But so far, there’s no sign that inventories are fattening.

Either this recession has not really begun and the utilization number is on its way down to the 70s, or the economy’s problems are more localized than everyone thinks. Almost all economists believe the credit crisis from mortgages and their derivatives has spread to the entire economy. Even if that had not soaked through the whole wadding, the rocketing price of fuel should be spreading its harm across all areas.

These puzzle pieces don’t fit. But, as I mentioned in March though, the caput number smoothes over some weakness. This is why inventory is not stacking up, because the reported number is for the total caput. The production of finished products is only at 76.9% capacity, and that’s in “slowdown” range, though not as low as the 2001-2002 recession. Manufacturing in general comes in at 79.2%, just slightly below normal. There’s more weakness in utilities, though. That area now measure 85.2% of capacity compared with an average level of 86.8%.

It’s the strength in the third component that is masking these slowdowns. Mining is now operating at 89.2% of capacity, which is notably higher than this group’s 87.5% average and far above the 83% and 84% levels it showed during the past two recessions.

This also helps explain why production figures are holding up as well as they are. We are producing very well—in mining.

Still, the whole picture is looking much better than I expected so soon. Let’s hope next quarter sees more improvement. Then we can put another one behind us.

As soon as we get the cost of gas and groceries under control, that is.

Source: This is a Strange Recession

And I’m certain you’ve read about this trade here in the A-Letter – the infamous currency play, known as the “carry trade.”

But still with all this publicity, carry trades remain a mystery to most mainstream investors. Even the carry trade basics – including what it is and the mechanics of placing this trade – elude most investors.

So let me take just a moment to explain what a carry trade is – and why this one trade has been behind some of the most explosive trends in the currency markets for years. Also, I’ll explain why this one trade is about to come undone this year and create some explosive profit opportunities if you’re positioned correctly.

It’s Really So Easy: Borrow, Convert, Reinvest

Though commentators can make this sound complicated, it’s not. Think of it as a simple three-step process and I think you will have the mechanics of a carry trade nailed.

Three-step process that defines a carry trade:

1. Borrow the low cost currency i.e. low interest rate currency
2. Convert the borrowed currency into currency of your choice
3. Reinvest into:

• Deposits of other high yielding currencies
• Stocks
• Bonds
• Commodities
• Real Estate
• Derivatives
• You Name It…

The currency you borrow in step one is often called your “carry trade currency” or your “funding currency.” That’s because this borrowed currency gives you the funds to reinvest as defined in step three. So keep in mind that “carry” and “funding” currency is often used interchangeably in financial literature.

Okay. The process looks easy enough, but why is it, or why was it, so popular? The reason is because it was profitable. It’s very enticing to be able to borrow inexpensively, reinvest and immediately achieve a much higher return. There’s lots of money to be made on the spread…

Spread = Return on Investment in Higher Yielding Assets – Borrowing Cost

…or at least that’s the theory.

For example, say you borrow at 1% then turn around and reinvest the proceeds at 6%. You’ve just earned yourself a quick 5% return without much work. This of course assumes the asset yielding 6% in this example holds its value. If the asset you buy with the carry proceeds falls in value, you have a capital loss. Thus it eats away at the spread that once looked so enticing.

In fact, this is where the problem comes in with the carry trade – it’s based on simplistic assumptions. But incredibly, these simple assumptions didn’t stop fund managers and institutions across the globe from borrowing trillions of dollars to reinvest those assets. And they add massive leverage to boot.

Three Things a Carry Trade Needs to Grow and Thrive

You need to have three major criteria (which are assumptions when projected into the future) for the carry trade to be of any significance:

1. Low borrowing rates from a major central bank – as highlighted above, it comes down to perceived profitability of borrowing cheap and buying or lending at higher rates to achieve the spread. But for a global carry trade to take wing and fly there must be a major global central bank behind the trade (Bank of England, European Central Bank, The Fed, Bank of Japan, etc.). For example, if the central Bank of Zimbabwe were offering 0.5% interest rates, they could not realistically produce enough loans to make it significant. Not to mention they have absolutely no credibility when it comes to monetary policy and a stable currency.

2. Low volatility or weakness in funding currency – if the currency you borrow weakens, or at least remains stable, then your risk is limited to the return available where you invested the proceeds. If the currency you borrow begins to appreciate in value relative to the investment you purchased, then profits begin to fall.

3. Low volatility or strength in invested asset class – As long as the asset class you bought e.g. other currencies, stocks, bonds, etc. with the borrowed proceeds increase in value faster than the underlying borrowed currency, the trade is profitable. But if the assets you bought start to decline in value on a relative basis, your losses can mount quickly.

So there you have it. It’s a straightforward process. And if the funds and institutions didn’t bet so much money on such simplistic assumptions, the carry trade would be relatively innocuous. Unfortunately, not only did they bet big by borrowing trillions, but they turned around and “leveraged it up” many times over. In other words, they used margin to supercharge their carry trade borrowings so they could buy more stuff. After all, it was working for a long time so why change?

Back When All Assets Were Soaring…

From 2001 through most of 2007 almost all asset classes were moving higher and higher in virtual lockstep. Not only that, the volatility of the move was extremely low.

Stocks, gold, and crude oil all moved up together through June of 2007. Thus, we had a happy credit induced bubble ridding merrily higher.

But the game changed come July 2007 – dramatically. The markets bit back, proving what Milton Friedman told us many years ago, “There is no such thing as a free lunch.”

Stay tuned…I’ll give you the full story on how the game has changed tomorrow.

JACK CROOKS, Editor of The Money Trader and World Currency Options

P.S. Tomorrow I’ll tell you why the carry trade currencies rocketed higher and why the new era of the great unwind could change the game for a long time to come and set the stage for some excellent long-term currency trading opportunities. Or you can read my FREE report right now to get all the details on this explosive new trend.

It’s one year later. From what I hear from my dad, after plunging the Merrill Lynch bond is back up. And the Bank of Nova Scotia’s shares are exactly where they were a year ago. That’s much better than most North American banks have done over the past year.

No harm, no foul?

I’d be the stupidest guy on the planet if I thought that there were no lessons to be learned just because these investments didn’t turn to mush.

Fact is, my assumptions have changed. If my dad showed me the same Merrill Lynch bond today, I would’ve told him not to touch it.

And I wouldn’t have cared if a high-ranking official from an American bank swore to me they weren’t exposed to the subprime mortgage market. I wouldn’t have believed him. I would definitely have put off investing.

The housing bust, subprime mess, credit crunch and resulting financial crisis have done more than just bring the market down.

They’ve led to a stunning collapse of confidence that has infected the entire investment world. Banks don’t want to lend to each other … institutional investors don’t know what’s safe anymore … and retail investors don’t believe anything anymore.

How can they? The rating agencies have proved beyond a shadow of a doubt that they do not understand derivatives. Their ratings are worthless.

And the brokers and analysts who follow every twist and turn the market makes? It must have made them so dizzy that they can’t see the forest for the trees. They’ve been making one bad call after another.

Just a couple of weeks ago, for example, Buckingham Research estimated that Bear Stearns had $35 billion in liquid assets and borrowing capacity, enough to operate for 20 months. Turns out it had enough for three days. This is one of dozens of examples I could cite.

There’s so much uncertainty in the investment world that we can no longer fall back on our long-held ideas of what makes a safe investment.

Munis? Sorry, thanks to the shaky status of the monoline insurance companies (which insure munis), they’re no longer the safe investments they used to be.

Money market funds? They’ve been hit too. Some brokerages are covering losses with their own money rather than pass it on to those who invested in these supposed safe havens.

Good move. I don’t blame them.

Corporate bonds? The spread on what you can earn from them is tempting, but along with falling employment there is increasing evidence that Wall Street’s problems have become Main Street’s. By no means can these be considered rock-solid safe investments.

What’s left? Oh, yes, how could I forget. U.S. government bonds. Okay, they’re still safe but are they really investments? I mean, can anything you get a negative return on be considered an “investment?”

I don’t think so, and that’s exactly what you’re getting with them. A ten-year note would give you 3.6 percent yield.

Inflation is running at 4.1 percent, and that excludes food and energy prices. The real rate of inflation (as my colleague Rusty McDougal would attest) would be much higher.

U.S. bonds are worse than giving the government a free loan. Instead of the government paying you extra money for the loan, you pay the government for the privilege of loaning it money.

Do you feel honored? Or cheated?

Well, I can’t speak for you. But this is the kind of honor that could land me in the poor house. I’d say cheated.

Well, is there any investment that is truly safe?

There sure is. Australian government bonds have never looked better than they do right now. And it’s the perfect time to jump into them…

Not only because Australia has one of the strongest economies in the world. Unemployment is at a 33-year low. And prices of its two big exports – coal and iron ore – are at historical highs. It doesn’t hurt that around 66 percent of Australia’s exports are commodities.

And not only because Australia is effectively shielded from the problems we’re having in the U.S. They trade mostly with fast-growing Asia. In fact, 60 percent of its exports go to Asia.

The biggest reason the timing couldn’t be better is because the Aussie government has been raising its key interest rate to stave off inflation. They’ve raised it all the way to 7.25 percent.