Most people do not know what CDS's, Credit Default Swaps, are or have even heard of them, but they have the potential to sink every bank in the country! No joke. Banks have trillions on the line with these CDS's and they are losing big. Credit Default Swaps are used by speculators to bet uncertainty of banks and financial institutions. The ill fortunes of banks and the mortgage business have sent CDSs into the hundreds billions of dollars. Speculators get paid off huge with all the foreclosures and write offs.
A Credit Default Swap is just a friendly bet made by two parties. Party one bets some event will happen like a bank's credit rating will fall or the entity will fail to pay bonds. Pension funds used derivatives to hedge against millions in bonds they own. So if the bonds fail they still collect on the derivatives. But speculators used the loophole to buy huge amounts of CDS's and then spread rumors a bank was in trouble with mortgages.
Speculators first buy CDS's with a bank and then they short the bank. This means as the banks stock price falls their CDS's go way up in value. Speculators start rumors that the bank is having trouble and they cause a panic. As people hear the bank has trouble they pull their money out of the bank causing the bank's stock price to sink even lower. Then the Speculators plant even more news stories and buy more CDS's. In the end the Speculators sink the bank, like Lehman, and they make millions in the process.
Only Fannie Mae and Freddie Mac were in terrible shape. It didn't take much to get people scared and make a run on the bank. This is why Washington Mutual, WAMU, failed so fast. WAMU could have lasted and sold themselves if they had more time but the speculators used naked shorting and rumors and within days people were pulling their money out of WAMU and the FDIC had to step in and takeover WAMU. The SEC let these speculators act like pirates on the high seas! They wreaked havoc on the fragile mortgage industry and made themselves rich by telling lies basically.
But in a wicked turn of events these CDS contracts could become worthless. It seems that as these banks collapse and are taken over these CDS's become defunct and non enforceable with the change of ownership. There is nobody to collect from and speculators end up holding worthless paper. Granted this paper was worth billions just last year. The mistake the speculators made was agreeing to a contract that wasn't guaranteed. These speculators paid millions for the rights to these CDSs and now they don't even get that money back.
Now we see the Bush administration is bailing out the banks and the speculators will get paid after all! In a normal capitalist market we would sell the banks off, the CDS's would become worthless, and a new bank would emerge. For some reason our Treasury Department and the Federal Reserve think we have to save these banks from collapse. Why? I would rather they just buy the banks out, make the CDS's worthless, and setup a national bank owned by the government. It would be far cheaper than having to pay out all these CDS's that will start appearing in the next years!
I hate writing this, but it appears the Bush Administration wants to help its friends out and their rich shareholder friends out more than the taxpayer. Ask them why they don't just say to the banks "You will soon be insolvent and we know it. The only way to survive is to sell your self to us very cheap and get $1 or $2 per share. We won't have to pay out the CDS's and therefore we will become profitable very fast". But no! The Bush administration will save these banks and pay off the speculators and stick you and me with the 2 trillion tax bill. This is not capitalism. This is cronyism! Part 2 is coming soon.
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Steven Fox, a jack-of-all-trades when it comes to life.
Steven loves sports, chess, nature, science, computers, stocks/investing,
and just being curious on how everything works. Steven loves helping people and
that drives his strong curiosity. Writing articles is a great way to share ones knowledge. Steven
works atSoftware to Fit and writes for United States Vice President.
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Great article Steven, but would the administration have to buy the bank out? This could get extremely expensive, it seems. I'm not very savvy in this sort of thing but as many as were failing it appears that 800 billion would have soon been gone.
Thanks Joel. Great question, I will cover this in my next article too. They
could have bought Lehman for 3 billion probably. Lehman was worth 100
billion last year. Then they do what Richard Gere did in Pretty Woman.
Just sell the parts off and keep the banking portion for a national
bank. Wachovia could have been bought for 7 billion and it owns JD
Edwards which is worth 5 billion by itself. These banks got themselves
into a bind they never should be in and by getting themselves this weak
they are exposed. Look how fast JP Morgan bought Lehman. For example a
guy who got put into jail and needs to get out, but all his money is
tied up. He is willing to sell his 5000 gold watch for $150 as in the
movie Trading Places. The government was in such a great position to
make the taxpayers hundreds of billions. Respond to this comment
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