Financial Crisis 101: Why CDS could never work

image Behind Bars small Many still call or describe CDS (Credit Default Swaps) as a kind of insurance policy against credit risk to limit the risk of the lender. Well that might be so in their dreams or it has been used as a camouflage by the bankers to persuade the investors of the quality – or to mislead them on the lack of it – and suggest that there would be an underlying asset.

And that’s were all the problems start. To issue or construct a CDS there was never a requirement to actually being linked to, i.e. having provided or taken out the credit or having an contractual agreement with these two parties.

Everybody could issue CDS completely unregulated and unlimited. This is of course the reason for the incredible amounts being pushed around and it also provides the reason that – in rare cases CDS might have been an insurance against credit defaults – but in general these papers were only betting slips if certain events might occur most similar to betting on horses or dogs races.

If these instruments would have only been allowed to use for insuring against actual financial risks everything would be fine today – no so called Banking crisis.

But these instruments so far almost completely have only been used like bets and even worse as we will show below. One example:

Let’s say you are insuring your house against fire for 1 million dollar but its only worth 200,000. Now another hundred people bet that your house does not burn down for a million each.

As long as your house is still standing, everybody wins. But if it burns down 101 people want a million dollar. Now suddenly the destruction of the 200,000 dollar house has caused a 101 million dollar damage.

There are rules and regulations that such things don’t happen in the real world and if you would break those to such an extent, you would most likely end up in prison for many years.

First you can only insure your house for its value and in case of a damage you can only claim an amount the size of the damage.

Second you can only insure your house once or claim the damage in total – in short you can’t make a profit out of the damage. That’s how this is regulated in most countries today and there are many good reasons for that.

The only places where you have a logic very similar to how CDS have been used and caused this crisis, is with Bookies and at the casino – in gambling.

And there are three variables common to all forms of gambling:

  • How much is being wagered, the initial stake
  • The predictability of the event.
  • The odds agreed between the parties to the wager

The bookies are adapting the odds by how many people are betting on a horse or against it to limit their risk or – the other way around – to increase their profits.

And the casinos put maximum amount limits up and mathematical models to limit their potential losses to single lucky customers and increase their overall profits. And while you can say for casinos the bank always wins this seems to have been also the motto for the hedge funds and investment bankers when they adapted this bet model. And that elite of the banking industry got even that wrong.

They did not limit the risk for the bank – or did they already plan in that in case something goes wrong they, together with the politicians they bribed lobbied so massively that such bets would be allowed as so called financial instruments, will defraud / tax the money out of all other citizens?

And please forgive us that we like many insiders don’t believe that nobody could have known that this will fail gigantically. They only question was how long these Bankstas could rake in astronomical profits from these activities.

So there is maybe another way besides the anti-terrorist legislation to get a grip on these fraudsters.

Prosecute them under the gambling and similar regulations. As they have falsely represented the terms under which CDS and similar instruments were made legal, they certainly had no license for the kind of gambling they have undertaken.

From Michael Moore’s blog (link below)
“…3. BAIL OUT THE PEOPLE LOSING THEIR HOMES, NOT THE PEOPLE WHO WILL BUILD AN EIGHTH HOME. There are 1.3 million homes in foreclosure right now. That is what is at the heart of this problem. So instead of giving the money to the banks as a gift, pay down each of these mortgages by $100,000. Force the banks to renegotiate the mortgage so the homeowner can pay on its current value…”

Lets take a look at another example to explain the reasons why CDS and its unhealthy brothers and sisters caused this crisis.

Lets assume I invest one dollar into a company that is currently worth 10 dollars. I’m expecting the value of the company to rise to 100 dollar and by that, turn my dollar into 10 dollars – a nine dollar profit.

I nevertheless know that my investment bears some risks and now somebody approaches me and says: Pay me one cent and I will pay you one dollar in case the company goes bankrupt. Sounds great to me – my risk of loosing my dollar is now eliminated (I’ll of course not get the one cent back) and I still have the possibility to make my 9 dollar profit.

The person who is holding the bet (it does not matter here if you call it a bet or insurance) must (should) be certain that the company will not go bankrupt. He will therefore also offer this bet to others. Now these bets are – thanks to the deregulation by politicians massively lobbied during the last years by those offering these bets – in no way regulated or limited, but we assume that he finds another 10,000 people that pay him a cent for this bet.

And here is already the first big problem with this game mocked up in the banking world. In difference to betting at a bookie where there is either another person who will bet against you (like a buyer/seller pair in trade) or the odds would go up – in our example our issuer would ask for lets say 20 cents instead of one cent. By this the gambling industry puts up a safety limit or ceiling to limit the worst case losses – but not our super-clever 100 million dollar boni paid bankers – but maybe the bonus payments are the ceiling in their game.

But back to our example. Our issuer can now calculate his profit: 10,000 * 0.01 dollar = 100 dollar. Isn’t that great.

He will make that profit out of nothing without any assets. Its like “Feeding the five thousand” in the Bible, a miracle, just magic, the financial perpetuum mobile. Theoretically this is an infinite rate of return.

If anything goes wrong he will have to pay 10,000 dollar which he of course can’t because their are no assets or collateral to cover that or better said that would make sense to cover that.

But this is exactly what’s at the core of all these so-called bailout plans around the world. Covering up for crazy bets that only a mad man would do or – the other way around – paying out the profits to participants of a pyramid scheme where money simply travels up the chain.

Like their predecessors in the 18th century our days financial Cagliostros also hoped to cash in before and did not expect to be around when the whole bubble burst (these millions of dollar bonus payments suddenly get a completely different meaning).

From Wikipedia on Pyramid schemes
“A pyramid scheme is a non-sustainable business model that involves the exchange of money primarily for enrolling other people into the scheme, without any product or service being delivered. It has been known to come under many guises. Pyramid schemes are illegal in many countries, including the United States, the United Kingdom, France, Germany, Canada, Malaysia, Norway, Australia, New Zealand, Japan, Nepal, Sri Lanka, and Iran. These types of schemes have existed for at least a century…”

Now that might further clarify the way how those Bankstas could be prosecuted under gambling regulations, consumer fraud or the trade practice act.

It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning.
Henry Ford

More information:
Michael Moore: How to Fix Wall Street
Wikipedia on Alessandro Cagliostro
Wikipedia on Pyramid schemes

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