The next financial Armageddon?
by Anthony Cherniawski, The Practical Investor, LLC | February 22, 2008
PrintEveryone knows that homeowners insurance is designed to insure against fires and floods but few are familiar with credit default swaps, arcane financial instruments invented by Wall Street about ten years ago. Credit default swaps (CDS) were designed as “insurance” to reimburse banks and bondholders when companies failed to pay their debts. Credit default swaps have become so popular among banks that the Comptroller of the Currency (OCC), which regulates banks, reports that they are the fastest growing derivatives product in the market, growing 19% from the second quarter to the third quarter last year to $14 trillion in value.
The problem is, they are unregulated. Experts contend that, because credit default swaps have proliferated so rapidly, a hiccup in this market could set off a chain reaction of losses in financial institutions that will virtually dry up the banks’ ability to lend. The cost of protecting corporate bonds from default soared to a record as investors purchased credit-default swaps to hedge against mounting losses in the $2 trillion market for collateralized debt obligations.
``The market is full of rumors of unwinding of CDOs, and the price action suggests that people believe the rumors,'' said Peter Duenas-Brckovitch, head of European credit trading at Lehman Brothers Holdings Inc. in London. ``It sort of has that Armageddon feel, and the market is feeding on itself.''
This is more than just a tempest in a teapot. Already AIG, the largest insurer in the United States, has had to deal with pricing and risk issues with its independent auditors on some of the credit default swaps it holds. Societe Generale, the French bank that recently reported losses from a rogue trader, also has problems with CDSs. "The purchase of assets originating from asset-management funds invested in credit-type underlyings could continue in the first quarter and, given the situation in the credit markets, lead to further write-downs," the bank warned. Credit Suisse was forced to raise the coupon on a $2 billion note it was offering after reporting writedowns of $1 billion in the first quarter of 2008 dealing with credit-default swaps.
All of this must be leading to arguments between the boards of directors and their independent auditors at almost every major bank about the true value and risk of their credit-default swaps. The trouble is, they must have their 2008 reports signed off by their auditors and in the hands of the Comptroller of the Currency by February 28th, for the OCC’s year-end report. The problem is, practically no one can get a handle on the true value of their credit-default swaps because they are thinly traded, have huge counter-party risk, are unregulated and are difficult to analyze.
Next week I’ll talk about how the other side of the swap is treated.
Crash Alert!
Harry
Schultz commentary: “Pretend an emergency is coming, because it may
be.” Most people will ask, “Why worry about the market? It appears
to be recovering.” But Dow
Theory states that, once the primary trend is established, it can
last from a few months to many years. The rallies that may be touted
as recoveries by Wall Street are just secondary movements that act as
“release valves” to blow off some pressure in preparation for the
next move in the primary trend. Human behavior needs modification at
this point from “Buy the dips.” to “Sell the rallies.” The
primary trend is now down.
Higher consumer prices nail bonds
“The
Consumer Price
Index for All Urban Consumers (CPI-U) increased 0.5 percent in
January before seasonal adjustment, the Bureau of Labor Statistics of
the U.S. Department of Labor reported today. The January level of
211.080 (1982-84=100) was 4.3 percent higher than in January 2007.”
That’s only part of the story. The 3-month increase, compounded annually, was 6.8%. Is it any wonder that long term bonds, whose yields are only 4.55% aren’t holding up?
Gold says, “Inflation.” Stocks say, “Deflation.” Which is it?
NEW
YORK (MarketWatch)
-- Gold futures closed with gains after soaring to a new record high
of $958.40 an ounce Thursday, boosted by weakness in the U.S. dollar
and the metal's appeal as a hedge against inflation.
Gold remains in its up-trend, with no apparent letup. When will it stop? Let the market tell us.
Another major decline imminent in the Nikkei.
On
Thursday Japanese
shares rose 2.84%. Lest you think that a new bull market has
begun, I might add that the rallied followed a 3.25% decline the day
before. The trend is still decidedly negative, and may give way to yet
another major sell-off before its troubles are over. Japanese shares
are expected to open lower on Friday following the report on the
Philadelphia Fed February Manufacturing Index, which fell to –24.0
from –20.9 in January.
The Shanghai Composite poised...for what?
Banks
were on the mind of Chinese investors as their market
sold off today. A steep
fall among lenders dragged Shanghai's key stock index lower this
morning. Shanghai Pudong Development Bank Co led the drop on
speculation that the bank may raise as much as 46 billion yuan (6.4
billion U.S. dollars) from an additional share sale. The Bank
of China tried to reassure investors that their exposure to
sub-prime debt was minimal.
The U.S. Dollar is in a trading range.
NEW
YORK (AP) — The dollar
slumped Thursday as disheartening economic data poured in, while
the European Union gave an outlook that would show the euro zone
growing faster than the U.S. economy. What didn’t help was that
European and Asian stock indexes had a good day while the U.S. stock
indexes declined. The Labor Department reported a slight drop in the
number of people filing for unemployment benefits for the past week,
but the four-week average rose to 360,500 — its worst level in more
than two years.
Falling satellites meet falling home prices.
While many have fretted over the upcoming resets of
adjustable-rate mortgages, falling
home prices are a much more important concern. Home price declines
threaten to turn many recent homebuyers upside down – that is, owing
more than the home is worth. Falling home prices and tighter mortgage
credit in turn lead to even weaker housing conditions, further home
price declines and even tighter mortgage credit, and so on. Is there a
missile for falling home prices?
Plan for seasonal gasoline shortages
The Energy Information Administration’s This Week In Petroleum suggests that both planned and unplanned refinery outages will have a very large impact on gasoline prices in 2008. EIA expects (planned) refinery outages in late spring and early fall, since that is the time between peak heating and driving seasons when refiners typically do most of their planned maintenance. Expect the unexpected outages, too.
In a word, “Frigid” in the Midwest
The
Natural Gas
Weekly Update reports, “Spot
prices increased this week as space-heating demand remained strong in
large population centers in the Midwest
and Northeast. Continued cold temperatures and increased crude
oil prices, which rose to more than $100 per barrel yesterday
(February 20), contributed to increases in natural gas prices.”
Meanwhile, natural gas in storage fell last week, but remained 5.8% above its 5-year average.
Dr. Housing Bubble meets Mish…
…and a good interview results. As you know, Mish (Michael Shedlock) is very opinionated about all things economic. The problem is, he’s done his homework and goes far behind the headlines to arrive at his conclusions. So when strong opinion is backed by unassailable logic, the fur really flies. So read his interview to find out how changing attitudes will be changing the financial landscape.
“Some places like Florida (which was ground zero of the housing bust) may bottom earlier. Areas that didn’t experiences a boom like Detroit may just flat line for a few years. Places in small town USA may flatline as well. Vast areas in this country where there isn’t much real estate wealth may stay flat for a few years. But everywhere else there was a major bubble (all the major population centers), the bottom is still many years off.”
Copyright © 2008 Anthony Cherniawski
Editorial Archive
contact information
Anthony Cherniawski | President and CIO, The Practical Investor,
LLC.
State Registered Investment Advisor | Mason, MI USA | Email | Website
The opinions of FSU contributors do not necessarily reflect those of Financial Sense.
