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.

Financial castles of sand

sand castle

The Financial Times has a quite understandable, informative article about the collapsing shadow banking system and how it is impacting real banks and the financial world at large.

How crazy did it get?

Satyajit Das, an author and derivatives industry expert, cites an example where just $10m of real, unlevered hedge fund money supports an $850m mortgage-backed deal. This means $1 of real money is being used to create $85 of mortgage lending.

Little of this was regulated, because CDOs and SIVs are not real banks. While this allowed them to do insane things, it also means that, unlike actual banks, they have no lender of last resort to bail them out.

But they were borrowing from real banks, who now will suffer real pain too.

Most of these vehicles, and the shadow banking sector as a whole, is supported by back-up liquidity lines with “real” banks – promises to lend money that bankers never imagined they would have to deliver on.

The rot is not just in the US. Municipalities in Australia may sue Lehman Brothers after CDOs Lehman sold to them are now worth pennies on the dollar. And a Canadian bail out by a consortium of banks has failed before it got started, just like the US effort (deemed by some as the “Save Citi plan”) also has.

Not only were municipalities buying this now toxic waste as supposedly safe investments, so were pension funds and enhanced money markets, maybe your pension fund…