50-60% haircut on Greece bonds could trigger CDS

Flickr napfisk

It wasn’t enough that the banksters sold garbage bonds and made dicey loans to Greece. Nope, they had to make huge bets on them too. Of course they made money doing both and certainly assumed if things went bad they could go whining to governments that they need another bailout.

Well, it’s game over on that. The coming massive haircuts on Greek debt will not only show the insolvency of the banks it will trigger enormous Credit Default Swap events where the seller of this faux insurance has to pay the buyer. We are talking gazillions here.

[this] will render the central bank immediately insolvent all else equal. What it also will impact is treatment of all other banks and pledged collateral valuations which is effectively the only bridge in the chasm between Mark to Unicorn and reality.

So, the Eurozone banksters will do what they do best, pretend the whole thing isn’t happening. God forbid they ever face up to the extent of their incompetence, greed, and corruption.

Leveraged debt and the current debt crisis

Credit default market . NY Times.

Image from NY Times article, Arcane Market Is Next to Face Big Credit Test, an article which is getting huge circulation among financial blogs as it is makes public to the world at large what the financial blogs have been saying for months, that the coming debt crunch could make subprime seem small.

Few Americans have heard of credit default swaps, arcane financial instruments invented by Wall Street about a decade ago. But if the economy keeps slowing, credit default swaps, like subprime mortgages, may become a household term.

Sudden Debt has a clear explanation of this impending debt market crisis.

The investment bank factories synthesized a whole array of artificial goods, ultimately far removed from the income streams of the underlying assets:

1. CDOs and CLOs, i.e. tranched bonds made up of loan packages.
2. CDSs on the above bonds, i.e. credit insurance policies.
3. Hybrid and synthetic CDOs, i.e. bonds made up of the above CDSs.
4. SIVs that issued their own ABCP in order to buy and hold the above “goods”.
5. CPDOs that were structured to own CDS income streams.

… and more…

The alphabet soup seems thick and opaque, but don’t let the jargon confuse you. Here is the crucial point: almost all of these “securities” were unfunded debt, i.e. money equivalents created from thin air. All they did was to generate more and more “buying power” to boost asset prices higher, from houses in the Inland Empire of California to share prices in New York, London and Shanghai. In case it is still unclear: it was margin debt.

If you are familiar with buying stocks or commodities on margin, you can immediately appreciate what went on, and why all current attempts to avert a wider crisis will fail miserably for as long as the focus is on the symptoms, instead of the underlying illness. Margin debt cannot be “restructured” with falling asset prices. Period.

In other words, this entire pyramid of bizarre financial instruments was created and paid for with borrowed money. A hedge fund borrows ten million to create CDOs, which they then use as collateral to borrow more money to create even more debt instruments. Some hedge funds and investments can be leveraged 30 to 1 or more on this. That means they’ve bought $30 worth of securities on credit for every actual dollar they have. So, just a few mild breezes could easily knock such a house of cards down. Especially when some of what they bought is now worthless or selling for pennies on the dollar assuming a buyer could be found.

But with margin money, the clock is ticking. If the asset value drops below a predetermined level, the borrower is then forced to sell whatever they can to pay back all or part of the loans and can not hold in hopes of the price coming back.

Credit default swap losses may reach $250 billion

Shadow banking system reserves. PIMCO

Bill Gross of giant bond management company PIMCO says losses on credit default swaps could reach $250 billion based on historical default rates.

To put that number in perspective, many Street estimates ascribe similar losses to subprime mortgages, a derivative category substantially distinct from CDS insurance.

With CDS, a bond issuer sells risk to the buyer who agrees to make good on defaults above a certain level in return for an income stream. They can’t call it insurance because only insurance companies can sell insurance, but that’s what it is. But insurance companies and banks are required to have cash reserves to meet black swan events, buyers of CDS are not. He calls this the shadow banking system, a huge, unregulated entity now filled with hidden icebergs of risk and lurking catastrophe.

“Buyers of protection” will be on the other “winning” side, but the point is that as capital gains and capital losses slosh from one side of the shadow system’s boat to the other, casualties and shipwrecks are the inevitable consequence.

This also spells, in his view, an end to the neocon style of capitalism.

Market based, regulation-lite American style capitalism, seemingly so ascendant after the dot.com madness nearly a decade ago, has met its match with the subprimes and the poorly structured and supervised derivative conduits of today’s markets.