Thursday, September 25, 2008

The Debts of the Spenders: CDS Part II (Private Casino of the Rich and Infamous)

In case I didn't make clear in the last entry, CDS (credit default swaps) are the rich's private futures market.

Unlike regulated futures markets such as the CBOT or NYMEX where financial instruments are traded openly, CDS are traded in the OTC (Over the Counter) market. This means that there is no way to transparently view pricing mechanisms. It is difficult - but not impossible - to find the bid and ask price spreads.

In the NORMAL futures market, brokers act quickly to shut down losing trades. They do this by requiring customers to post more margin or liquidate existing accounts. There is a clear chain of responsibility in the futures exchanges - in the unlikely event customers are unable to meet their trading losses, their brokerage firms are responsible for meeting the losses. In the even more distant possibility of default by the wirehouses, the exchange itself is obligated to make the counterparties whole. Finally, both the brokers and exchanges possess billions of dollars worth of individual insurance.

There is NO such mechanism in the CDS market. In fact, until a few days ago the CDS market was not even regulated! Traders played in a gray realm of insurance, futures, and options compliance where the market was deemed "too big to fail".

Trading losses were bundled into mortgage packaged loans (CDOs or collateralized debt obligations) and sold to unwitting suckers like the NY Teachers Pension Fund or some village in Japan. When this private casino finally collapsed, Wall Street approached Main Street to ask taxpayers to pay for their gambling debts.