The truth is that U.S. regulators believed the American public couldn’t handle the truth that what had been allowed to happen, on their watch, was actually happening.

Unfortunately, we now face the same situation with credit default swaps, a derivative security that has the ability to destroy otherwise healthy companies with the virulence of a full-blown plague.

Until the American public understands this, and forces the government to take action, the odds of a repeat performance of what we refer to as the global financial crisis remain very high.

This is not an “Origin of the Species” seminal epic. Rather, it is a short story about the failure of evolutionists to recognize that, while creationism actually starts somewhere, it is actually the failure of regulators to evolve as institutions and markets change that makes monkeys of us all.

Let’s start by looking at the Federal Housing Finance Authority (FHFA), the current regulator of Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FRE), two players who were central to the start of the U.S. housing crisis, which became the contagion that grew into a full-blown global crisis.

It’s bad enough that the regulators who came before the FHFA were inept, but what is happening now under the FHFA is far worse, and actually has the potential to exacerbate a crisis that most taxpayers believe is being resolved.

For more than six months, the U.S. Justice Department and the Securities and Exchange Commission (SEC) have been investigating the accounting practices of the two mortgage behemoths. And now the FBI has gotten into the act. It seems that, not long ago, the FHFA hired renowned investigative firm Kroll Inc. [One of the powerful, one-named, spook-like firms – not unlike Blackwater Security Consulting – Kroll is a unit of New York-based insurance powerhouse and “risk advisor” Marsh & McLennan Cos. Inc. (NYSE: MMC)].

Kroll’s confidential report to the FHFA concluded that “inappropriate application” of accounting rules “enabled Freddie to defer billions of dollars of losses incurred from 2001 through 2004.” The source of those losses, according to a Wall Street Journal article, was derivative contracts based on interest-rate swaps.

What’s the big deal you ask? While it’s no surprise that Freddie used an inappropriate set of rules – known as “hedge accounting” – to stretch out losses over several years, rather than just take immediate hits to its profit-and-loss statement, what is frightening is that the FHFA, after hiring Kroll and uncovering the accounting inaccuracies, said it had decided “not to take issue with the accounting,” the Journal reported.

The FHFA labeled it as a “disagreement among the experts.” Call it what you want, but I call it fraud.

Here’s the problem. Fannie and Freddie are incredibly “fragile” right now (the correct financial term is probably “insolvent”). That means that the very two institutions being used by government to halt the catastrophic slide of the U.S. housing industry are so crucial to the bailout of the mortgage industry that to force these two institutions to write off more losses would only spook the financial markets even further.

As large as Freddie and Fannie are in the U.S. housing and mortgage markets, even their combined portfolio value – estimated at about $13 trillion – is dwarfed by an exponentially larger and even more insidious monster running over regulators like they’re not there. I’m talking about the $40 trillion stranglehold that the credit default swap market has on corporations all around the world.

Credit default swaps brought insurance giant American International Group Inc. (NYSE: AIG) to its knees. It was also one of the key catalysts that helped transform a housing bubble into a full-blown global financial crisis.

But here’s the rub: After all that, credit default swaps still aren’t regulated.

Of course that doesn’t mean that regulators don’t try and insert a hand here and there, it just means that the hand they insert has been feeding the monster rather than taming it. But, just recently, a good faith public relations effort was made to show the new interest the revitalized SEC has in reining in the monster from Hades.

In what amounts to a minor case with major worldwide implications, the SEC has brought insider trading allegations against a credit default swap trader and his source of inside information. It is alleged that Renato Negrin, formerly a trader at hedge fund Millennium Partners LP, received inside information from Jon-Paul Rorech, a salesman at Deutsche Bank AG (NYSE: DB). Supposedly, Rorech provided inside information to Negrin about the potential value of certain credits of VNU NV, a Dutch holding company that owns Nielsen Media and other media businesses

It doesn’t matter that Negrin no longer works at Millennium, or that both men say they are innocent, or that the alleged ill-begotten gain was a measly $1.2 million, or that the two men’s lawyers say the SEC has no jurisdiction over derivative contracts, period – let alone derivative contracts tied to European bonds.

What matters is that the SEC has finally put its toe into the muck. According to ABC News, it’s the first insider-trading case involving credit default swaps

Nothing may come of it. But I, for one, will be watching.

It strikes me as tragically ironic that after the credit-default-swap market has been allowed to grow from a few wispy hairs into the tail that wags the dog, the SEC is just now trying to be more than a flea on the tail of this monster.

The real reason we are not hearing more about the catastrophic systemic danger unleashed by credit default swaps is that even the regulators who would like to be overseeing this huge market – if for no other reason than for the regulatory-driven fee income these securities could generate – are afraid to admit this market is still poised to unleash a capitalist plague unlike any that’s ever been seen.

Just as we saw with the role Fannie and Freddie played in the housing market, the credit default swap market has gotten so large and out of control that to admit there is a problem is to admit that the problem is so big and will be so difficult to unwind that the threat can’t be thwarted anytime soon.

But until the public recognizes that credit default swaps can be used to manipulate the credit characteristics, ratings and creditworthiness of corporate borrowers – and also be used to intentionally push down stock prices in a way that destroys good companies, this derivative security will continue to hang over Corporate America and the U.S. stock market like a capitalist sword of Damocles.

It happened with AIG. And it can easily happen again.

The tarnish dulling the prospects of America’s recovery needs to be wiped clean and in its place clear transparency into the workings of the U.S. financial markets needs to be implemented. It’s bad enough that we are in this mess and afraid to admit how deep the hole is. But one thing is for sure, if we don’t create a level playing field, if we don’t expose fraud, if we don’t rein in swashbuckling traders slicing and dicing up America’s corporate backbone, we will discover that this particular hole is bottomless.

But if we’re honest about the problems we still face – as well as what needs to be done – we will find that everyone can see a clear path to steer, and will navigate our way back to economic high ground.

Our leaders might be surprised, if they would only accept one basic fact: We can handle the truth – if we know what it is.

Source: How Credit Default Swaps Could Reverse the Economic Recovery

[Editor’s Note: Uncertainty will continue to be the watchword in the months to come. R. Shah Gilani – a retired hedge fund manager and a nationally known expert on the U.S. credit crisis – has predicted five key financial crisis “aftershocks” that he says will create substantial profit opportunities for investors who know just what these aftershocks are, and how to play them. In the Trigger Event Strategist , trigger events,” as gateways to massive profits. To find out all about these five financial-crisis aftershocks, and about the trigger-event profit strategy they feed into, The Trigger Event Strategist check out our latest offer.]

]]> http://www.contrarianprofits.com/articles/how-credit-default-swaps-could-reverse-the-economic-recovery/16741/feed 0 http://www.contrarianprofits.com/articles/ocean-piracy-fill-your-trading-account-with-booty-from-the-pirate-portfolio/15504 http://www.contrarianprofits.com/articles/ocean-piracy-fill-your-trading-account-with-booty-from-the-pirate-portfolio/15504#comments Mon, 13 Apr 2009 14:57:35 +0000 Marc Lichtenfeld http://www.contrarianprofits.com/?p=15504 The saga on the high seas continued… As much of the world continued to monitor the story of the American cargo ship that was captured by Somali pirates and held its captain hostage, the increase in piracy has sparked a fascinating conversation. 

It involves the use of innovative products that enable shippers to defend themselves from pirate attacks.

While it may not seem like a lucrative business, the uptick in high seas shenanagins over the past year or so threatens to become more prevalent if it’s not addressed. And with millions of dollars worth of cargo traveling by sea every day, both the shipping industry and the companies whose cargo they’re hauling hardly want to see the trend become a full-blown epidemic.

At…

This from Investor’s Daily Edge:

The election’s over. President-elect Barrack Obama won, and some people are worried that he’ll start taxing dividends like income. Have I got news for you… that’s the least of our worries on the dividend front.  Put it in the drawer for next year’s hand wringing.

Because just when you thought the financial news had exhausted all the bad stuff and you had found safety in dividend stocks, I have to give you a heads up. Your stock could be getting a pension fund “margin call.”

I love dividend stocks. These companies have cash, pay cash, and keep the faith with investors for the most part. But some are on the verge of breaking that faith this year. It has nothing to do with mortgages or credit markets – it’s about pension funds in trouble.

And when pensions are sucking up cash flow, your dividends could suffer. Mercer, a pension consulting firm that is part of Marsh & McLennan (NYSE:MMC), already estimates that pension shortfalls will lead to a 10% cut in stock dividends this quarter compared to a year ago.

That’s a big deal. Even the 2003 squeeze on pension funds after the three-year-long post-dot-com bear market didn’t cause that. In fact, this could be the first time pensions have been hit so hard since 1958.

Pension plan contributions are a normal expense that companies handle just as they pay the electric bill and management bonuses. But pension plans are special. The funds are separate from the general coffer and there are rules on how much money the plans must have compared to the benefits they’ll have to pay out. This is true in the U.S., Canada, UK and Europe. And though I will use U.S. examples, British and European stocks are also under pressure.

In the bull market years of the 90s, keeping a pension fund properly funded was no problem for most companies. Their funds were flush with stock, and stocks were going up. In fact, before Enron spoiled everyone’s party, some pension funds were loaded with roaring hot company stock. (The post-Enron limit is 10% in company stock in the company pension fund.) Pension funds were making money.

Obligations were fully covered and then some. Some funds were so flush the companies were able to stop putting money in them for several years. They even showed earnings from pension funds as “other” income on balance sheets, making their earnings look better than they should.

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GE (NYSE:GE) was famous for smoothing its earnings by including pension fund surpluses in its figures. Some critics called this maneuver “vapor earnings.” These vapor earnings fattened the bottom line sufficiently to bring fortunate GE execs an extra 9% in their bonuses.

Now comes today… after a bear market… into a recession. Vapor earnings are vaporizing. As of September 30, S&P 500 companies’ pension funds have lost an average of 11.6%, according to CFO magazine. They are now about 92% funded. That’s just barely OK… for a couple more months.

For many years, U.S. companies only had to keep 90% of the present value of expected obligations in their accounts. The Pension Protection Act of 2006 will raise that “coverage ratio” gradually to 100%. For 2008, the magic number is 92%. And it goes to 94% in 2009. So this 92% funding estimate means that some companies pass muster, and a lot don’t.

Standard and Poor’s says S&P 500 pension plans were $200 billion short of minimum funding levels by the end of September this year. Worse, they were on target to surpass the $219 billion record shortfall of 2003.

Who’s in trouble? What stocks to avoid? Remember that funding a pension is a normal business expense. So it’s not every company that shows a pension obligation that should bother you, but the ones that show likely shortfalls that could overwhelm earnings.

Among the companies with big pension plans that are likely to need a large shot of hard-to-find money are Lockheed Martin (NYSE:LMT), United Technologies (NYSE:UTX), Aetna (NYSE:AET), Boeing (NYSE:BA), IBM (NYSE:IBM), Eastman Kodak (NYSE:EK), Goodyear (NYSE:GT), Ford (NYSE:F) and GM (NYSE:GM).

Those are just the big names. By industry, the most underfunded pensions are concentrated in information technology and healthcare. Utilities also slipped from overfunded last year to coming up short this year.

The good news is that companies have to give you a warning in their financial reports—the bad news is that you have to read the suckers. At least if you do it online, you can use a search and go straight to the “pension” part of Management’s Discussion.

Source: Another Fancy Disaster You Didn’t Need – Pension Fund Vapors

And that’s precisely the wrong decision to make at the wrong time. No matter how poorly the financial markets are performing, saving for retirement has to remain a top priority.

“It’s not a time for people to stop contributing,” Diane Young, director of retirement and goal planning at TD Ameritrade Holding Corp. (AMTD), the Omaha, Neb.-based brokerage firm that conducted the retirement study, said in an interview with Bloomberg News. “Because time is money, it’s important to stay on track.”

According to the Ameritrade study – released yesterday (Tuesday) – 63% of Americans have completely stopped contributing to their retirement plan. Financial strain due to the economic downturn was cited by half (50%) of those who say they have reduced or stopped contributing to their retirement plan. Unemployment (32%) and healthcare costs (25%) also were cited as key factors affecting their ability to contribute to their retirement plan.

Only 54% of survey respondents, which included senior citizens, indicated they had a retirement account. Of that number, one out of three had less than $50,000 in investment assets.

But slacking off on retirement savings now is only going to hurt you more down the road.
Chipping Away at Retirement Assets

Giving up the power of compounding can be the most costly mistake an investor can make when it comes to investing for retirement, but unfortunately that’s just what many are doing in light of the dismal market performance.

And those dismal returns aren’t the only factor hammering the bottom line of retirement accounts these days. Retirees and those close to retirement are feeling as if they are under attack from all sides due to the factors that threaten a comfortable retirement.

The main source of income for many retirees continues to be the Social Security Administration. But the Social Security program has been at risk for years as life expectancies continue to grow and the number of retirees advances in kind. The program will only come under more pressure as the baby boomer generation edges closer to retirement.

“Social Security’s current annual surpluses of tax income over expenditures will begin to decline in 2011 and then turn into rapidly growing deficits as the baby boom generation retires,” the most recent trustees’ report said.

Many retirees depend on dividend payments from investments to supplement income. But with a growing number of companies reducing or eliminating dividend payments in the face of poor earnings or a changing business landscape, that income stream is dwindling.

Even companies with long track records of dividend growth, such as General Electric Co. (GE) and Bank of America Corp. (BAC), have been paring back.

Given the current market conditions, selling a stock that has eliminated its dividend is no longer as likely to make up for that lost income.

“If I’m down 25% in dividend income, but the stock is down 35%, if I sell the stock, can I afford to lose another 10 to 15% by selling?” Howard Silverblatt, a senior index analyst with Standard & Poor’s, told The Associated Press. “Younger investors can wait the market out and sell the stock when it bounces back. But older people are really stuck in a bad spot.”

Companies with poor earnings are also cutting back on company contributions to 401(k) plans, which can downright wreck your expected retirement calculations. General Motors Corp. (GM) recently announced that it would discontinue company-matching contributions for non-union employees until economic conditions improve.

According to a recent survey by Watson Wyatt Worldwide Inc. (WW), 2% of companies surveyed have already decreased 401(k) contributions, while another 4% are planning to do so in the 2009.

Retirees with defined benefit or pension plans aren’t in much better shape.

According to Adrian Hartshorn, an actuary with Mercer, a business consultant subsidiary of Marsh & McLennan Companies Inc. (MMC), the pension account assets of companies in the S&P 1500 are shrinking. At the end of 2007, the companies Hartshorn tracks had a collective surplus of $60 billion. But stock-market losses have transformed that $60 billion surplus into a $35 billion deficit.
Protecting Your Retirement

If you find yourself the victim of a cutback in company contributions or a loss of dividend income, make sure you take the initiative to safeguard your retirement.

“Redo your financial planning and figure out if you need to save more now,” Robyn Credico, Watson Wyatt’s national director of defined-benefit consulting, told The Washington Post.

Here are some more steps you can take to help protect your retirement account, even during difficult market conditions:

* Be Aware: AARP’s website has a number of interactive financial calculators that will help you estimate everything from how much you need to save for retirement to how much income you can expect during retirement. While you want a long and healthy life, you don’t want to outlive your money, so be sure you don’t underestimate your time horizon.

* Be Proactive: If you think you’re going to come up short when it’s time for retirement, reconsider your options. Some workers are delaying retirement to give their assets more time to grow. Other retirees are supplementing their income with part-time work or curbing expenses by cutting back on unnecessary expenditures.

* Be Thrifty: Save as much as you can. Make sure you’re getting the most out of your company 401(k) plan by maximizing the company match. And try to save the maximum annual limit for your company’s 410(k) plan or your traditional IRA. Contributions to your retirement account often reduce your taxable income, so it might not be as much of a sacrifice as you think. Indeed, some investors do double damage to themselves by ending their retirement plan contributions, but forgetting to also adjust their tax withholding. That can make for an ugly surprise at tax time – either with a smaller-than-expected tax refund or a bigger-than-expected tax bill.

* Be Investment Savvy: Align your retirement investments with your time horizon and risk tolerance. Generally, younger investors can tolerate more risk, while those closer to retirement need to choose more stable options. Money Morning Investment Director Keith Fitz-Gerald recently recommended American Century Capital Preservation Fund (CPFXX) as a “safety-first” investment choice for investors close to retirement. And don’t be overly dependent on dividend income or a company pension fund, both of which could be affected by overall poor market conditions or weak company earnings.

Source: Four Ways to Protect Your Retirement From the Ongoing Financial Crisis