October 14

It's time for a quick lesson on credit derivatives; "weapons of mass destruction" as Warren Buffett likes to call them. The first three articles listed below deal directly with these nasty fellows, and based on my research, these are what have the potential of causing collapse. At the very bottom of this message is research/teaching regarding what credit derivatives are and how they work.

A reminder to all that I am an extremely positive person, always hoping for the best. Nevertheless, I am also a realist, and I don't see how, despite the world's governments trying their best to intervene, we're going to avoid a collapse. The first article below discusses the idea that these credit derivitives are valued at 10 times the entire world's global output. The next article mentions that all it takes for financial stability to unravel is "failure of one link in the chain" The following article discusses the bankruptcy of countries around the world... Well, it doesn't take a brainiac to realize that there are billions of links in the global financial chain, from AIG to Iceland that could contribute to what the director of the International Monetary Fund calls a "systemic meltdown." (see article below).

So, if the financial system could unravel at any time, people, it's time for a plan! In all my reading, the number one survival tactic deemed necessary is the coming together of communities. This goes totally against the individualist natures that we have all grown up with, so the first step is just to begin thinking about who you might want to be grouped with, and where that community will exist. When communications companies go bankrupt and you are unable to communicate with family, then it is too late. Start doing some prep work now about the assets within your family system, as well as allegiances with friends.

I hope you find this all helpful and look forward to chatting with you on the blog.

Jill


UK Independent: $516 Trillion Derivatives Market Timebomb Has Blown
The market is worth more than $516 trillion, roughly 10 times the value ofthe entire world's output: it's been called the "ticking time-bomb". It's amarket in which the lead protagonists – typically aggressive, highlyeducated, and now wealthy young men – have flourished in the derivativesboom. But it's a market that is set to come to a crashing halt – the GreatUnwind has begun. Last week the beginning of the end started for manyhedge funds with the combination of diving market values and worried
investors pulling out their cash. The derivatives markets in which these
hedge funds played has been dubbed the world's biggest black hole . . .

UK Independent: Traders Worst Fears Realized at Lehman's AuctionDerivatives traders were yesterday nervously picking their way through thewreckage of the Lehman Brothers bankruptcy in what was the biggest testof the unregulated $60 trillion credit default swaps market. Investors whohad placed bets on Lehman's creditworthiness held an auction aimed atclarifying who owes what to whom after the investment bank went bustfour weeks ago, and analysts believe that several hundreds of billions ofdollars will change hands. The insurance giant AIG was one of the biggestsellers of Lehman Brothers credit default swaps, and it faces big losses asa result. It had to be bailed out by the US government three days after theLehman bankruptcy filing, and has so far been extended $123bn in loansfrom taxpayers. What investors and regulators fear is a failure to pay by one link in the chain could cause a cascade of losses through the system.

NY Times: Insurance on Lehman Debt the Next Gauntlet to Run
First the house of Lehman fell. Now the insurance bill is coming due. Nearlythree weeks after the Wall Street bank sank into bankruptcy, financialcompanies and investment funds that wrote what are effectively insurancepolicies on Lehman Brothers’ debts are being called on to pay hundreds ofbillions of dollars in claims. Whether those claims can or will be paid, andthe financial repercussions that could follow if they are not, will signify thebiggest test yet for the vast, unregulated market in credit-default swaps.

UK Telegraph: If You Think the Worst Was Over, It's Time to Think Again
Our fear explains why Friday’s sell-off was so brutal. This delayed reactionto a month of almost unbelievably bad news in the credit markets wasdriven primarily by ordinary investors – Mr & Mrs Average finally deciding tocash in their pension nest egg for fear it might be cracked beyond repairby Monday. All round the world, fund managers reported a huge surge incustomers demanding their money. The professionals panicked long ago.
UK Independent: Global Financial System at Brink of "Systemic Meltdown"
As we return to work this Monday morning, let the words of the directorgeneral of the IMF, Dominique Strauss-Kahn, ring in our ears. Mr Strauss-Kahn, having spent all Saturday with finance ministers in Washington D.C.,warned that the global financial system has been pushed "to the brink of asystemic meltdown". And he added that the measures taken thus far todeal with the financial crisis "have not yet achieved the goal of stabilisingmarkets and bolstering confidence". I stretch "systemic" to mean we areall affected by what has begun to happen – the shrinking of bank credit . . .

Wall Street Journal: Financial Danger Zones Emerge Around the World
Investors are feeding a dramatic world-wide slowdown by trying to flee it,racing away from many corners of the globe they used to favor. Theresulting tumbles in stocks and currencies have helped provoke a broadercrisis in places such as Iceland, whose turmoil in turn is hitting bankdepositors from London to Amsterdam. As foreign capital flows out of ahost of smaller economies, it's laying bare the excesses built up during fiveyears of strong growth and easy access to borrowing. Concerns are risingthat such countries could prove weak links in the world's financial system.

UK Telegraph: Many Countries from Pakistan to Baltics May Go Bankrupt
Nuclear-armed Pakistan is bleeding foreign reserves at an alarming rateleading to fears that it could default on its loans. There are mounting fearsthat Ukraine, Kazakhstan, and Argentina could all now slide into a downwardspiral towards bankruptcy, while western banks exposed to property bubbleacross Eastern Europe have seen their share price crushed. The marketsare pricing an 80pc risk that Ukraine will default, based on five-year creditdefault swaps– an insurance policy on a country being able to pay itsdebts. The country's banking system has begun to break down after yearsof torrid credit growth; its steel mills are shutting as demand collapses;

London Times: We Just Moved Closer to the Edge of a Financial AbyssIt has been a long, wearying weekend the world's most powerful financialofficials will likely live to regret. This was the moment when they peeredinto the abyss of global financial cataclysm — and then decided to take astep closer to the edge. It may yet live in infamy. With the eyes of theworld upon them and the bedrock of the global financial system crumblingunder their feet, finance ministers from the big Western economies decidedthat this was the ideal moment to show resolve only to remain irresolute;to decide only to stay undecided. It is the mother of all bungles . . .

Economist: "The global economy has begun to suffocate . . ."
Deprive a person of oxygen and he will turn blue, collapse and eventually
die. Deprive economies of credit and a similar process kicks in. As the
financial crisis has broadened and intensified, the global economy has
begun to suffocate. That is why the world’s central banks have been
administering emergency measures, including a round of co-ordinated
interest-rate cuts on October 8th. With luck they will prevent catastrophe.

Economist: Long Feared Surge in U.S. Bankruptcies is Now Under Way
Sharper Image filed for bankruptcy protection in February, and has sincebeen liquidating itself, getting even lower prices for its assets than it hadhoped. Several other well-known retailers have since gone bust. Steve &Barry’s, a casualwear retailer that is a core tenant of numerous shoppingmalls, terrified commercial-property investors when it entered bankruptcyprotection in July. It emerged in August with new private-equity ownersand a plan to close 103 of its 276 stores. Linens ’n Things filed in May, andat first hoped to reorganise itself and leave bankruptcy. After the collapseof a planned sale to Cerberus it now plans to liquidate itself, with closing-down sales due to start at its remaining stores on October 16th this year

Jim Puplava: Rapid Implosion of AIG Shows How Explosive Derivatives Are
Where this comes home to roost, you had a company like AIG, the largest
insurance company – a trillion dollar balance sheet. If you were to think ofa blue chip company that would be one of them. And the basic business ofAIG – their insurance divisions – they were profitable, they were makingmoney but they had one little division writing credit default swaps on thesecollateralized toxic securities and look what happened; they went from thelargest insurance company to receivership in two days . . . that’s where Ithink that saying that Warren Buffett said many years ago that derivativeswere financial weapons of mass destruction because when you can take atrillion dollar insurance company with a trillion dollar balance sheet and blowit up in two days, it just goes to show you how explosive these things are.

Market Ticker Forum: "It is now, quite literally, about the ability of food and fuel to reach our markets . . ."Sovereign debt (Treasuries from various nations) has become infected withtrash - unfortunately including ours now that Fannie and Freddie werenationalized and TARP has been passed - and may fail in a cascade-stylefashion across the world . . . We are facing a global DEPRESSION and thecut-off of essential goods and services in this nation if we do not stop thislunacy immediately. Please understand - the TRUCKER who has a full loadof food headed for your grocer REQUIRES commercial credit in order to fillhis truck with diesel. The local GAS STATION owner REQUIRES commercialcredit to fill his underground storage tank. . . . IF THESE MARKETS DO NOTIMMEDIATELY UNFREEZE THE CONSEQUENCE WILL BE THAT FOOD AND FUEL,MAY NOT FLOW TO YOUR GROCERY STORE AND GAS STATION.

James Howard Kunstler: "In Iceland, the people are stripping the grocery markets of whatever remains . . ."Iceland is the poster-child du jour for this. The little island nation of about320,000 souls (roughly half of Vermont's population) lately grew a bankingsector that thrived on something-for-nothing finance. In little more than amonth, its banks have imploded like mini death stars, leaving Iceland with apariah currency. Since it has to import just about everything, and it now
finds itself unable to pay for imports, the people are stripping the grocery
markets of whatever remains there now. You wonder what they will do in
two weeks. Ten years from now there may be 32,000 of them left . . .

Time Magazine: "Odds of Morgan Stanley defaulting within five years are 45%, for Citigroup the odds are 21%"
Now that fear is everywhere, how does Weiss feel? In some ways, morefearful than ever. Speaking over the phone from his office as marketsplunge around the world, Weiss, 61, says: "The possibility of a total financial collapse is higher than at any time I've ever seen. We just don'tknow how bad things could get." One thing that has him spooked is theprice of credit-default swaps for major U.S. banks — a derivative thatprovides insurance against the possibility they might default on their debt,dooming them to bankruptcy. According to data provided by Bloombergusing a model devised by JP Morgan, the price of this insurance currently mplies that the odds of banking giant Morgan Stanley defaulting in the nextfive years are 45%. For Citigroup, another financial linchpin, they're 21%."This is astonishing," says Weiss. "If Citigroup fails, it could be disastrous."

UK Independent: Financial System Crumbling like the Tower of BabelIt took centuries to build sophisticated free-market economies, but thisweekend, it looks like it may have only taken one week for it all to unwind.Not only have stock markets fallen to their lowest levels for decades, but,more than that, the assumptions that have underpinned commercial life foryears are now threatened, some possibly doomed. Banker is not trustingbanker, savers can trust no one, share traders do not trust governments,leaders (including conservative ones) suddenly discovered the virtues ofpublic ownership; and there is the very real prospect of a country in thedeveloped world actually going bankrupt. Today the world's leading centralbankers to prevent the crumbling financial system from cracking further.

Bloomberg: GM, Ford, Chrysler Face Bankruptcy Risk on Crisis
General Motors Corp., Ford Motor Co. and Chrysler LLC, the three biggestU.S. automakers, may be forced into bankruptcy as the global credit freezedamps U.S. sales, Standard & Poor's analyst Robert Schulz said. "Macrofactors could overwhelm them at some point'' even as GM, Ford andChrysler vow to stick with their turnaround plans, Schulz, S&P's lead automotive credit analyst, said today in a Bloomberg Television interview inNew York. The companies said they have no plans to seek bankruptcyprotection. His assessment underscored the pressure on the industry asthe worsening credit crisis makes it harder for buyers to get loans . . .

Forbes: Orange County Among America's Luxury Foreclosure Capitals
Numerous factors affect an area's rate of foreclosure. Unemployment andfalling home prices certainly play a part. Sen. Dick Ackerman might arguethat weather plays a role. He represents a sizable chunk of South OrangeCounty, including Laguna Niguel, and says that there is something aboutthe desirability of the area that makes the real estate market swing a littletoo far during boom and bust cycles. "People bought high-end homes whenthe economy was good, and now somepeople can't make their payments."

San Francisco Chronicle: Crisis Hits Bay Area Housing Market HardSan Francisco may be 3,000 miles from Wall Street, but the crisis that hasengulfed the country's biggest financial institutions is putting even morepressure on the Bay Area's real estate market, making it increasinglydifficult for home buyers to get credit. Cheap credit played a dramatic rolein fueling the housing boom of the late 1990s and early 2000s, particularlyin places like the Bay Area, where buyers relied heavily on unconventionalloans to purchase homes that would have otherwise been unaffordable,economists said. That cheap credit also played a dramatic role in topplingfinancial institutions like Lehman Bros., Washington Mutual and Wachovia.

LATOC: Where Are Things Likely to Go in the Short-to-Medium Term?
Civil unrest will break out in major cities when incomes fall but the cost offood and essential services fail to come down materially, leaving millions ofAmericans hungry, broke and homeless. Unlike in the 1930s America willnot quietly stand in soup lines - instead they will riot, loot and burn. TheNational Guard will be called but will find it impossible to exert meaningfulcontrol without shutting down all commerce in the affected areas. Thedecision will be made to cordon off the cities and deny entry to anyonewho does not live in that specific neighborhood, essentially shutting downcommercial activity. GDP will fall by 30%. The S&P 500 will fall to 150 andflatline, a 90% loss. CNBC and Bloomberg will cease broadcasting . . .

CREDIT DERIVATIVE 101
In finance, a credit derivative is a derivative whose value derives from the credit risk on an underlying bond, loan or other financial asset.
A credit default swap (CDS) is a swap contract in which a buyer makes a series of payments to a seller, and in exchange receives the right to a payoff if a credit instrument goes into default or on the occurrence of a specified credit event, for example bankruptcy or restructuring. The associated instrument does not need to be associated with the buyer or the seller of this contract.
In practice, as most other derivative products, the huge development of the market is not to be imputed to hedging purposes, but to arbitrage and speculation. Suppose that an investor holds neither bonds nor debts on company X, but thinks that this company may default. He can buy a CDS on X and pockets the pay-off in case of default. This strategy is equivalent, but more straightforward than short-selling bonds. The CDS market is also reported to have recently been used to bet on companies’ default after the ban on short-selling in financial stocks.
The size of the market has soared well above the value of the underlying debt that they are supposed to insure (reaching about $62 trillion at the end of 2007). This has become clear since 2005, when Delphi, the auto parts maker, went bankrupt: the CDS on Delphi’s debt in the market exceeded the value of its bonds tenfold.
All major financial actors are deeply involved in the market. From the beginning, in the mid-'90s, banks have used CDSs to escape from their capital requirements. But nowadays, banks, hedge funds, insurance companies and pension funds are hugely exposed as buyers or sellers, or both. By transferring the risk, the CDSs have acted as a kind of insurance and provided incentives for risk-taking. They are therefore at the heart of the present crisis.
The CDS market is now in the eye of the storm. The reason is straightforward, because this crisis is about credit risk. A credit bubble has ballooned for years, being enhanced by the existence of credit derivatives. As credit originators can pass their risk to other agents, they have been less careful about the quality of their loans. In that sense, CDS have given an incentive for distributing more credit to more risky borrowers.
As banks and all financial institutions have massively committed themselves in the CDS market, they are now highly dependant on market continuity and its smooth functioning. The failure of a major participant, or worse a whole set of participants, can put at stake all the others. Bankruptcies of Bear Sterns, then that of AIG, two key counterparties, could have brought about a complete meltdown of the market. This has certainly been taken into account when the US government decided to step in and prevent them from going bankrupt. However, faith in the reliability of the market has been deeply shaken by these events. Lehman Brothers’ bankruptcy has also severely hit the whole market, as it was among the 10 main participants.
Another cause for concern is that the market is unregulated. CDSs act as insurance against default, but they are not submitted to any regulations as is the case for insurance companies. The latter have to meet required reserves and are closely monitored by public authorities. On the CDS market, no reserves are required from the sellers of protection, only very thin margins, ranging from 2% to 5% of the amount insured. However, the danger is even greater than insuring against natural catastrophes for example, because of the high correlation of default risk, which is linked to the business cycle.