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/earnings-reports-will-play-a-key-role-this-week/15746 http://www.contrarianprofits.com/articles/earnings-reports-will-play-a-key-role-this-week/15746#comments Mon, 20 Apr 2009 15:05:54 +0000 William Patalon III http://www.contrarianprofits.com/?p=15746 When it comes to the U.S. stock market right now, the story continues to be about earnings. And this week will be no exception.

Bank of America Corp. (BAC), which reports today (Monday), remains among the last financials of note that has yet to announce its first-quarter performance, and the big bank figures to get a lot of attention as investors look to see how well Merrill Lynch & Co. Inc. (formerly known as “The Bull”) and Countrywide Financial Corp. have fit into the BofA family fold.

International Business Machines Corp. (IBM) (today) and Apple Inc. (AAPL) (Wednesday) will give investors a better idea of just how well the tech sector – which up to now has been quite hot – is really doing. Amazon.com Inc. (AMZN) (Thursday)…

Not only did the dealers pull their bids in both metals, but I highly suspect that there was actually some fresh shorting by the Non-Commercials and Nonreportables [in the COT] as well.

As I’ve been saying for the last week or so, an assault on gold’s 200-day moving average would materialize sooner or later, as a couple of the U.S. bullion banks [JPMorgan (NYSE:JPM) and HSBC USA (NYSE:HBC)] still had huge short positions to unwind. Well, this could be the start. And whether or not they are going to take their sweet time about it…or have it all over and done with by lunch time in New York today…remains to be seen.

Don’t forget that despite their attack on gold…silver is still the centre of the universe for the bullion banks. That’s why the attack on silver was far more ferocious than on gold If these two bullion banks [and a couple of others] have to cover some of their shorts with physical metal, there are central banks that can [and will] come to their rescue. The last time that happened was during the rescue of Long-Term Capital Management. They were short about 300 tonnes of the stuff. This option does not exist in silver because there just isn’t any…except for what’s sitting on the Comex in the USA…or in the SLV ETF in Britain. The bullion banks most likely own some of that silver, but there’s no way for us to tell.

So, how low could they take gold on this move to the downside? Just looking at the 2-year gold chart posted below, it would be my guess [in a worst-case scenario] that we could see gold in the $825 range, before it became ridiculously oversold. We’ll find out, as they say, in the fullness of time.

click to enlarge

Wednesday’s trading activity in gold showed a decline of 787 contracts, reducing the open interest to 336,143 contracts. In silver, o.i. fell a measly 17 contracts to 94,551. Thursday’s o.i. numbers, when they become available around noon Eastern time, should be interesting…as will be the COT report when it comes out at 3:30 p.m. today.

According to the Comex Delivery Report, there were a decent amount of gold contracts delivered yesterday…429 to be exact. The big deliveries came from the Bank of Nova Scotia [320] and Prudential Bache [102]. The big stoppers were Bank of Nova Scotia [188] and JPMorgan [127]. There were four contracts delivered in silver. Over at the Comex-approved silver warehouses yesterday, another 305,864 ounces were taken off the exchange…the lion’s share came from Brink’s, Inc. There were no changes in the SLV ETF…but over at GLD, it was reported that 8.25 tonnes were removed…265,200 ounces troy. As the usual N.Y. commentator stated…”This was the first significant change since March 24th: GLD itself lost 7.5% over that period.”

The N.Y. commentator also had this to say…”The Bombay Bullion Association has announced that imports into India for the first half of April were 10 tonnes, compared with 25 tonnes for all April last year. Imports in Q1/09 were, of course, negligible – in fact, some gold is said to have been exported.” This is supported today by John Reade at UBS…”We updated our Indian gold sales database yesterday and note that the sporadic [holiday-interrupted] demand we have noted over the past couple of weeks has turned into a modest bounce in our index…including some reasonably strong demand yesterday. This clearly suggests to us that India is de-stocked after the recent scrap outflows from the country…and that buying is taking place ahead of the April 27th festival. This bodes well for demand later in the year and suggests that any further major correction in gold will see solid buying.” Reade also reports Western demand is still present: “…we have had some detailed conversations with our Zurich-based physical gold experts and also with some contacts in the refinery industry. We can confirm that coin demand remains strong, with sales limited only by coin availability…and scrap supply has slowed to a trickle compared to the floods seen in Q1.” As a result of the powerful early Comex selling raid [the 3rd in three days] The Gartman Letter is now short another gold unit…Now the trick will be to get out profitably. With what appears to be a sea-change having come over the Eastern physical market, this might not be so easy. Is this a bear trap in the making?

In other gold and silver news, I see in a yahoo.com news story that Central Fund of Canada has completed the sale it announced last week. The final numbers are as follows…in gold they added 123,700 ounces, and in silver the total came to 6,188,000 ounces. It will take them a couple of weeks to get the gold…and heaven only knows how long to get all that silver. They won’t tell you, even if you ask nicely. All inquiries in prior offerings, at least by this humble scribe, have been met with stony silence.

I have three stories today. The first one has received a lot of press already. This one comes from Bloomberg and bears the headline “General Growth (NYSE:GGP) Files Biggest U.S. Property Bankruptcy”. As I’ve mentioned on several occasions this year…commercial real estate is one of the shoes yet to drop. Here’s the first sign of big trouble…and as a Realtor with 27 years of experience…I can tell you that it’s going to be horrible beyond belief before this is all over. I thank P.S. for sending me the story…and the link is here.

My second story is also from Bloomberg. The headline reads “Dresden Job Losses Leave It Reeling as East German Boom Fades”. It appears that the bloom is off the rose in the formerly communist eastern Germany. I thank Craig McCarty for the story and the link is here.

The last story is from the Financial Times in London. It carries the very provocative headline “Is America the new Russia?” It would appear, in certain important respects, that’s exactly what’s happening…although some people would call it Fascism instead. It’s hard for me to believe that things could have come to such a state in the U.S.A. But if you’ve read G. Edward Griffin’s classic tome: The Creature From Jekyll Island: A Second Look at the Federal Reserve…you won’t be the slightest bit surprised. I once again thank P.S. for sending me this story, and the link is here.

Today, being Friday, will be an interesting day in the New York markets. As I put this to bed at 3:00 a.m. Mountain Daylight Time, I see that both gold and silver have taken tiny swan dives in early London trading. Not a lot…but it’s probably enough to set the tone for the precious metals market for the rest of Friday trading…which has 15 hours and 15 minutes to go as I hit the ’send’ button to my editor. Be ready for anything.

All of us at Casey’s Daily Resource Plus look forward to seeing you right here once again on Saturday.

Source: And Then There’s This…Friday, April 17th, 2009

General Growth filed for Chapter 11 seeking protection from creditors after it amassed $27 billion in debt accumulating over 200 shopping mall properties. The filing covers 158 of its U.S. malls, but excludes its joint-venture properties and third-party management business.

The Chicago-based company – the country’s second largest shopping mall owner – owns such valuable properties as Fashion Show in Las Vegas and Faneuil Hall Marketplace in Boston. It listed total assets of $29.56 billion and total debt of $27.29 billion.

“We intend to emerge as a leaner company,” General Growth President Thomas Nolan told Bloomberg News in an interview. “We want to come out as a less leveraged company. Our business model remains strong.”
In the eyes of many observers, the filing brings the U.S. real estate collapse full circle as commercial properties values are now plummeting in concert with the ailing residential housing market. Commercial real estate prices in the U.S. dropped 15% last year, according to Moody’s Investors Service (MCO).

Many commercial real estate companies have been squeezed out by the credit crunch as banks continue to curb lending.

Nolan said General Growth was a victim of “a broken capital market.” No one could have predicted the severity of “the credit markets shutting down,” he said.

Last November, General Growth warned it might have to seek protection from its creditors because it was unable to refinance maturing debt obligations. The company was trying to restructure bonds it floated to finance a $14.3 billion all-stock deal for Rouse Co., a high-end mall dealer it bought in 2004.
“It just tells you that this debt can’t get redone, especially for big properties,” RBC Capital analyst Rich Moore told Reuters.

“General Group has long been the poster child of too much debt,” said Moore.”General Growth has malls, and malls are some of the biggest assets out there.”

Analysts said the bankruptcy might allow competitors to cherry-pick some of General Growth’s more desirable properties, giving Simon Property Group Inc. (SPG) the opportunity to bolster its position as the No. 1 mall operator.

“I think Simon’s going to be able to pick up some of these assets on the cheap,” Dan Fasulo, managing director at real estate research firm Real Capital Analytics, told Bloomberg.

However, Fasulo also called General Growth’s filing “the beginning of the end,” which could lead other companies to fail.
“This bankruptcy will drive down the values of mall assets in the United States. It’s going to put, I believe, more supply on the market than can be absorbed by investors,” he said.

About $814 billion of commercial mortgage debt is expected to mature over the next two years, which will only serve to put more pressure on the market, according to real estate research firm Foresight Analysis.

Meanwhile, the residential market chimed in with its own bad news.  On the same day General Growth filed, the U.S. Department of Commerce said builders broke ground on 10.8% fewer homes in March and new permits fell to a record low, as homebuilders sought to rein in inventory amid rising foreclosures.

“Buyers seem to be more interested in picking up bargain- basement prices in the existing-home market than in the new-home market,” Robert Dye, a senior economist at PNC Financial Services Group Inc. (PNC), in Pittsburgh, told Bloomberg News.

Source: General Growth Files Biggest Real Estate Bankruptcy in U.S. History

• General Growth Properties Inc. (GGP) warned it is on the brink of bankruptcy, as slow retail sales have forced many of its mall vendors to close their doors, CNNMoney.com reported. The nation’s second-largest shopping mall operator said in a SEC filing that it has more than $950 million in property and corporate debt, and is facing another $3.07 billion in debt that matures in 2009.

• Sales fell 7% in the third quarter for Macy’s Inc. (M), leading to a $44 million loss, or 10 cents a share. As a result, the Cincinnati-based retailer said it is cutting capital spending by as much as 45% in 2009, MarketWatch reported.

• Oil continued falling faster than it rose, as December futures for light sweet crude slid $3.08 overnight to $59.01 a barrel in electronic trading on the New York Mercantile Exchange. The sharp fall is blamed on concerns that global growth next year will clock in slower than expected, the Associated Press reported.

• October retail sales in China rose a robust 22%, sending a strong signal that its powerhouse economy could stand tall amidst global recession. The sales growth is nearly its fastest pace in nine years, Bloomberg reported.

• Yum Brands Inc. (YUM) said yesterday (Wednesday) that it would cut “several hundred” jobs as it restructures its U.S. business. The company plans to reduce the percentage of Pizza Hut and KFC restaurants it owns to from 20% to 10% by selling units to franchisees. The company will continue to own 20% of all Taco Bell restaurants.

• Anheuser-Busch Cos Inc. (BUD) shareholders yesterday (Wednesday) approved the $52 billion takeover offer from Belgian rival InBev NV. More than two-thirds of the Budweiser brewer’s shareholders voted, with 96% voting in favor of the deal. Anheuser-Busch and InBev will form the world’s largest brewer if and when federal regulators clear the deal.

Source: Global Investing Roundups Thursday, November 13th, 2008