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Struggling To Stay Alive in the Credit Default Swamp

By Susan C. Walker
Fri, 03 Oct 2008 16:30:00 ET
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One of my favorite comic strips that I didn't get to read enough of before it ended in 1975 is "Pogo."  The title character was the little everyman opossum who lived in the Okefenokee Swamp with his animal friends. They all spoke in a funny kind of argot, which the strip's creator, Walt Kelly, called Swamp-speak.

The most famous line delivered by Pogo was, "We have met the enemy, and he is us." That sentiment perfectly captures what the muck-a-mucks on Wall Street should be thinking as they look around the financial landscape and realize that the credit default swaps they purchased as insurance against their risky securities bets have all blown up.
 
When the dollar amount of CDS's floating around reached more than $60 trillion in 2007 compared with the annual U.S. GDP of $13 trillion, somebody on Wall Street should have guessed that the center would not hold. Seems that Pogo's compatriot, Dr. Howland Owl, the swamp's resident expert, could have pointed out that imbalance in such a way that the rest of the swamp dwellers could have understood it.
 
But we don't need Pogo or Owl to do that. For a good discussion of why the credit default swaps became a swamp for all the major players, we can turn to the latest Elliott Wave Financial Forecast by Steve Hochberg and Pete Kendall.
Don't believe in bailouts? You shouldn't miss the latest Elliott Wave Financial Forecast, published in the midst of the biggest financial bailout plan in history. In it, you’ll discover why both the bailouts and short-selling ban are badly misguided interventions that are already backfiring. Read more here.
Excerpted from The Elliott Wave Financial Forecast, October 2008
 Credit Default Swamps
To get an idea of just how much bigger the problem is than any possible solution the federal government can come up with, let’s look back at a financial instrument that we first introduced to Elliott Wave Financial Forecast readers in May 2005, the credit default swap (CDS). When Elliott Wave Financial Forecast first discussed these instruments in connection with the economy’s unavoidable advance toward the purge phase of the interest rate cycle, we also noted the appearance of “some whole new risk exposures such as credit default swaps, which by some estimates now total more than $8 trillion, or 2/3 of GDP.” At that point, the CDS boom had only just begun. The bar chart above shows the exponential growth that has since taken place. At $62 trillion, credit default swaps’ value hit 4.3 times annual U.S. GDP at its peak last December.

 

The extraordinary part that these instruments played at the very end of the Great Asset Mania’s peaking process revolves around credit’s pivotal role in the boom-bust cycle. Every boom runs higher when the willingness to lend disconnects from the value of the underlying collateral. Borrowed money ratchets up demand, pushing up prices and increasing the supply of credit. The bust comes when optimism finally wanes and the cycle reverses. Tighter credit reduces demand, driving down prices and the attendant collateral values. But the CDS introduced an intermediate step by allegedly allowing bond holders to insure against default, which they did in droves. We say allegedly because, as Conquer the Crash points out, default itself will nullify many insurance and derivatives contracts, even those that were supposed to pay off in the event of non-payment. In the summer of 2006, Elliott Wave Financial Forecast noted that CDS’s were being “widely used as insurance against default in lieu of selling distressed bonds outright.” In other words, the CDS’s delayed the selling that otherwise would have come naturally, a fitting component of the b-wave rally. The CDS market was obviously becoming a casino unto itself because total issuance eventually grew to be 6 times the total value of U.S. corporate debt. Its size and wild swings in value caused Elliott Wave Financial Forecast to issue several warnings:

The use of credit-default swaps in an attempt to avert defaults is a good example of the “creativity” that debt engineers are using to push the boundaries of the debt bubble further past those of 1720 and 1929. —Elliott Wave Financial Forecast, February 2007

The numbers suggest that the subprime problem could be small by comparison. —Elliott Wave Financial Forecast, February 2008

The sky is the limit for this mushroom cloud. —Elliott Wave Financial Forecast, September 2008

 All it took was one major credit event to bring down the CDS house. The failure of Fannie and Freddie tipped the first domino, AIG. In the chain reaction that followed, Wall Street firms used the instruments to drive each other out of business or into drastically different financial entities. According to Bloomberg, “The swaps became a one way bet on the demise of the financial institutions as traders hedged the risk that their partners might implode.” The SEC now promises to “crack down” on the unregulated CDS market, but any such move should prove superfluous, as credit default swaps will go away just as portfolio insurance disappeared after the 1987 crash. The first tick down after 7 straight years of growth has already occurred. CDS’s will, however, be long remembered as a monument to the level of complacency at a Grand Supercycle-degree peak.


Don't believe in bailouts? You shouldn't miss the latest Elliott Wave Financial Forecast, published in the midst of the biggest financial bailout plan in history. In it, you’ll discover why both the bailouts and short-selling ban are badly misguided interventions that are already backfiring. Read more here.


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