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Good morning from Cape Town

Whew – what a wild week! World stock markets and commodities tumbled, whereas government bonds and the US dollar surged amid mounting fears that the ongoing turmoil in financial markets was foreshadowing a hard landing for the US and Europe.

Now that the bailout deed has been done, attention is shifting to whether the plan will work and break the logjam in the credit markets. What do you think?

Read the views of a variety of commentators in my weekly “Words from the Wise” review: http://www.investmentpostcards.com/2008/10/05/words-from-the...

Be careful out there and remember the old adage telling us to hope for the best while preparing for the worst.
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Great column. Lots of info there. I loved the cartoon "any given sundae" and the red stamps on the banks.

Warren Buffett favored the bailout and that says a lot. Will it work? I think it will help us to have a more orderly economic decline. I think the $700 B will be printed (not borrowed) so there will be major inflation down the road.

I would love to hear your comments on this analysis from Porter Stansberry.

How AIG's Collapse Began Run on the Banks
http://boards.fool.com/Message.asp?mid=27059798

Peter
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Nice to see you back, Dr. du Plessis. I thought you gave up on METAR. I was about to post a link to your good article.

As for what I think...I think that the bailout could be the biggest opportunity for financial chicanery, at taxpayer expense, in U.S. history...and that's saying a lot.

It may help break the logjam for lending. But it won't do anything to solve the CDS problem. The loans will still exist (albeit in government hands), and some will still default, causing CDS cascades.

Wendy
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I'd like to add....I think your weekly roundup of pundits is excellent, unequalled by anyone else.

A different approach, which complements yours, is taken by Doug Noland at www.prudentbear.com. Mr. Noland is unequalled at collecting raw data. His Credit Bubble Bulletin has been predicting this crash for at least the last 4 years (the time I have been reading him).

An obscure statement in this week's Credit Bubble Bulletin is easy to overlook, but may be the first rumblings of the next crisis.

http://www.prudentbear.com/index.php/commentary/creditbubble...


October 2 – Dow Jones (Shara Tibken): “Sixty-one U.S. companies defaulted on their debt in the first three quarters of 2008, nearly quadruple the number last year. More than half were since late May, according to… S&P. Nine U.S. companies defaulted in September, including Lehman Brothers… and Washington Mutual… Through the first five months of 2008, the year-to-date total was 28, which was already more than the 16 seen all of last year and the 22 from 2006. The U.S. speculative-grade default rate climbed to 2.68% in September from 2.5% in August…”
[end quote]

Many corporate mergers in the past 3 years were financed by debt that contains "toxic waste" features, such as "covenant lite" and/or "PIK-toggle." These enable companies to take on too much debt and/or to interrupt interest payments without going into bankruptcy.

With a deepening recession, many more companies will default on debt payments. As we all know, the danger of debt (vs. raising capital using equity) is that debt payments cannot be cut like dividends, to conserve cash -- except the toxic ones.

The problem of defaulted interest payments still hasn't shown up on the radar screen. The government bank bailout generally covers mortgages and other consumer debt CDOs, but not corporate debt.

I predict accelerating defaults in interest payments, even if the PIK-toggle clauses avoid formal bond default (which is why I didn't buy any of those bonds). I believe that the CDS market would treat interest interruptions as a "credit event." That's why I'm worried about a CDS cascade, which the bailout doesn't address.

Wendy
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That's why I'm worried about a CDS cascade, which the bailout doesn't address.

Wendy,

Would you lay out the consequences of a CDS cascade? All I can grasp is that it would be a Really Bad Thing.

I haven't seen anything which talks about new regulations for CDS, but I have seen reports of new CDS sales. Is that correct? To me that sounds like a doctor telling a Stage 3 alcoholic that the next drink will kill him and the patient responding by going to a bar.

What will it take to bring CDS under control (defined as not posing a ginormous risk to the global financial system)?
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The problem of defaulted interest payments still hasn't shown up on the radar screen. The government bank bailout generally covers mortgages and other consumer debt CDOs, but not corporate debt.

If you look at the wording of the bill it does include corporate debt. And if I understand it right, leaves the choice up to the Treasurey Departement. There is nothing to stop them from choosing corporate debt over consumer, imho.

I think "they" have focused on the mortgage debt to keep us from looking at the rest of the debt.

Question....

Do the CDSs expire? Can the clock run out on them? I hope I'm asking the question so you know what I mean. I'm too new at this.

Jean
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<Would you lay out the consequences of a CDS cascade? All I can grasp is that it would be a Really Bad Thing.>

A CDS cascade would be a Really Bad Thing. Great way to put it.

A CDS (Credit Default Swap) is a private, unregulated insurance contract.

Let's say that I buy a bond, because I want the interest payments. Looking at Fidelity, today, here is one choice.

GE CAPITAL INTERNOTES 5.00000% 03/15/2017 FR
CUSIP 36966RW69

Pay Frequency SEMI-ANNUALLY
Coupon 5.000
Yield to Maturity 7.45%
Maturity Date 03/15/2017
Moody's Rating AAA
S&P Rating AAA



Wow, that looks like an excellent yield, especially given the high rating. But, even before the financial crisis started, there is always a possibility of default.

I phone you. "Meg, would you be able to insure the GE Capital Internotes? I will pay you $100 to insure $100,000 worth of notes."

You think, "Wow, what a deal! GE will never default on its notes. It's free money in my pocket."

So you answer, "Sure, Wendy, I'd be glad to insure your notes. Let's make a deal. You send me $100 for 5 years, and I will insure your notes."

I send you $100. Every year I send $100, just like any other kind of insurance. Now I can list my GE bond's asset value at par, regardless of market problems, because it's insured. I know that I will get at least my principal back, even if GE defaults.

You love getting my payments. You think, "What an easy way to make a living!" So, you start to offer the same kind of policy to lots of other investors. You never expect GE to default. It's free money with no risk. (A broker actually said this, plaintively, to a WSJ reporter.)

CDSs are private contracts. Unlike regulated types of insurance (e.g. homeowners, life), you don't have to hold a minimum amount of capital to back up your promise to me. The government has no control over CDS contracts at all. They aren't listed on any exchange.

Now someone else phones to ask for insurance against the default of GE bonds. They don't own any bonds, but they want to gamble on GE defaulting. You don't care whether they own the bonds they are insuring. They fork over $100, and you insure them for $100,000. It's like buying life insurance on someone else's life.

Since there are no regulations, you can insure as many bonds as you like. You collect the premiums, and take on the liability for the notional value of the bonds that are insured. Billions. Trillions. The notional value of CDSs is said to be $65 trillion. That's 10 times more than the actual bonds.

You like this business. You sell some of your CDSs. You pay for CDSs with other insurers.

Uh, oh. Now there's an economic depression. GE can't pay its notes. It defaults.

Now I phone you. You owe me $100,000. That's what I bought, with my insurance payments.

Everyone else who you insured, for the bonds that defaulted (whether they own the bonds or not) also calls you. You owe a huge amount of money. HUGE!

To scrape up the money, you phone the insurers who now owe YOU money. Unfortunately, they have also sold on some of the CDSs. They don't know who owns the liability now, or even if they are in the U.S. Who owes you the money? They don't know. All the CDS insurers are frantically trying to figure out who owes what to whom.

Total mess.

The only way to even begin to get this under control is to have a transparent exchange (like the stock market, except for CDSs). The SEC has been pressuring the CDS business to set one up for over a year. They are only partly there.

The government can't cancel existing contracts. That's the law. But they can begin to mitigate the problem by restricting CDS insurance only to actual owners of bonds, and only for the par value of the bond. That isn't anywhere near happening.

Wendy
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<Do the CDSs expire? Can the clock run out on them? >

A Credit Default Swap (CDS) is a private insurance contract between companies. Each one is for a specific period of time. Like a bond, which pays interest for a specific period of time, the CDS will produce an insurance payment for a specific period of time. They are traded in the market on the basis of the NAV (Net Asset Value) of the specific cash stream (the insured paying regularly, vs. the risk of default of the insured bond).

If no more CDSs were ever issued, the existing ones would eventually age out.

Wendy
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The government can't cancel existing contracts. That's the law. But they can begin to mitigate the problem by restricting CDS insurance only to actual owners of bonds, and only for the par value of the bond. That isn't anywhere near happening.

===================

Great explanation.

In the larger picture, the more I think about this, the more I believe CDS instruments should be banned, even for actual owners of bonds. The presence of CDS instruments only abstracts away the analysis of risk that must be the first order factor in any decision to borrow and lend money. If you're lending money and worried about the borrower's ability to pay, raise the interest rate to collect more up front while the borrower IS making payments to compensate you for the risk they might eventually stop or DON'T LEND THE MONEY.

One may think it serves some higher purpose for expanding growth and economic activity when things are going relatively well and predictably but the presence of CDS type securities actually accelerates the creation of phantom money. THAT is the root of the entire problem.


WTH
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I believe that from Bernenke and Paulson's perspective, the CDS isssue IS the big deal. The reason their original 3 page pplan was so nebulous was so they could stick their fingers in the dike whenever ANYTHING (sub-prime, student loan, car loan, credit card debt, corporate debt - anything) looked like it was going to default. This would give them breathing room to address the CDS thing without having to fight with the media over each decision (which out of systemic context might look out of place).

There are a lot of moving parts to this faltering economy and these guys must feel like their juggling a torch, a baby, a chainsaw and a bowling ball.

Another point: Let's take Wendy's example of my taking out a life insurance policy on my neighbor without informing them. It would be to my advantage to poison their drinking water to force a "credit event" (think "manipulative" short selling or false news reports). I've only bet $100/10,000 - that's pretty exciting leverage if I've placed enough black chips.

The restriction on short selling evaporates this week. I feel that despite the arguements that short selling makes for an efficient market, at this point they add complications which don't provide enough incremental benefit to the economy to be worthwhile permiting (until things reach a steady state again).

Jeff
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This is an awesome post, Wendy. If I could recc this 10 times I would. This is the basis for the whole derivative problem, which goes way past the $62T in CDS. Wash, rinse, repeat, with many other types of derivatives, to a tune of between $650T and $1Q, depending on who you read. The mess is inextricably linked and the only way to fix it is to let all entities go down and reboot with a new set of rules.

Recc Wendy's post, this is the best thing she's ever written and it explains the fundamentals of the whole mess, and why we're going down, hard.
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Thank you.

Any chance there are any companies that didn't engage in this mutual suicide pact (oh sorry, meant "sound business practice")? Are those are the companies you invested in because they did recognize the risk premiums were too low...?

A cascade would cause those insurance contracts to be triggered. Now I understand the WMD comments. At least the minefield would be cleared.

But it does seem to me that by not regulating new contracts *now* all we are doing is adding to the (switching metaphors) the fuel load the wildfire that's coming will have.

What's taking so long to get a transparent exchange for CDS? The lack of traceability? Why can't they start from a date and say henceforth all CDS sold will be subject to insurance regulations using XYZ mechanisms to ensure transparency? I understand that would do nothing for the current problem, but at least it would limit future additions.
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<Any chance there are any companies that didn't engage in this mutual suicide pact (oh sorry, meant "sound business practice")? Are those are the companies you invested in because they did recognize the risk premiums were too low...?>

I wish I knew the answer to that. I try to invest in solid companies with long histories of producing goods and services. But the balance sheets don't list "Credit Default Swaps" separately.

Bond default insurance is considered reasonable and responsible. An insured bond is given the credit rating of the insurer. That's why the failure of AAA-rated AIG would have caused such a catastrophe. All their swaps and bonds they insured would have to be downgraded at once. <holding head in hands>. To avoid that, the government simply nationalized them.

<What's taking so long to get a transparent exchange for CDS? The lack of traceability? Why can't they start from a date and say henceforth all CDS sold will be subject to insurance regulations using XYZ mechanisms to ensure transparency? I understand that would do nothing for the current problem, but at least it would limit future additions.>

Occasionally, the WSJ will print some information about this. The computers aren't in place. The software isn't set up yet. And the regulations aren't written fully. The systems needed for traceability and enforcement aren't there.

The stock market evolved over centuries. Getting the CDS system working all at once is complicated.

Wendy
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The mess is inextricably linked and the only way to fix it is to let all entities go down and reboot with a new set of rules.

Installing new operating systems usually takes some period of time. What's your estimate of how long it would take to reboot with a new set of rules given the following steps?

1. Write the new rules
2. Get consensus on the new rules
3. Write the code & test
4. Distribute the code
5. Install and trouble shoot
6. Install and troubleshoot applications
7. Return to productive work
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Because we're going to have to reboot the political system at the same time as the economic system, I'd say 15-20 years, Meg. The political system will cycle into the blue screen of death after the economy freezes up.

Stages of Collapse

Stage 1: Financial collapse. Faith in "business as usual" is lost. The future is no longer assumed resemble the past in any way that allows risk to be assessed and financial assets to be guaranteed. Financial institutions become insolvent; savings are wiped out, and access to capital is lost.

Stage 2: Commercial collapse. Faith that "the market shall provide" is lost. Money is devalued and/or becomes scarce, commodities are hoarded, import and retail chains break down, and widespread shortages of survival necessities become the norm.

Stage 3: Political collapse. Faith that "the government will take care of you" is lost. As official attempts to mitigate widespread loss of access to commercial sources of survival necessities fail to make a difference, the political establishment loses legitimacy and relevance.

Stage 4: Social collapse. Faith that "your people will take care of you" is lost, as local social institutions, be they charities or other groups that rush in to fill the power vacuum run out of resources or fail through internal conflict.

Stage 5: Cultural collapse....


http://cluborlov.blogspot.com/2008/02/five-stages-of-collaps...
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Because we're going to have to reboot the political system at the same time as the economic system, I'd say 15-20 years, Meg. The political system will cycle into the blue screen of death after the economy freezes up.

This seems a little far-fetched to me.. we've had plenty of economic resets without political collapse in this country... why would this time be specifically different?

~w
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Warren Buffett favored the bailout and that says a lot.

Warren Buffett favored the bailout *after* he had made a large bet that it would be enacted.

I haven't heard a thing that indicates what his view was before that bet.
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warrl:
Warren Buffett favored the bailout *after* he had made a large bet that it would be enacted.

I haven't heard a thing that indicates what his view was before that bet.


***************************************

I have put a fair amount of money into BKH over the last 3 months while I mostly moved to cash. I did not do this based on the image of WB as a kindly and wise old man. My mental image of him is of an old scar-faced pirate constantly checking the latest routes of galleons, the timing of gold shipments, and the going price of virgins.

Great investment, like Queen Elizabeth's in Sir Francis Drake.


david fb

p.s. I know times are strange when I rec almost every one one of warrl's posts, and it's an election season!
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This seems a little far-fetched to me.. we've had plenty of economic resets without political collapse in this country... why would this time be specifically different?

usually, they come up with a war on foreign soil to both distract the US citizens and also to boost the economy
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usually, they come up with a war on foreign soil to both distract the US citizens and also to boost the economy

Eh, the Great Depression went on for ~10 years before war broke out, with no political coups in the U.S. The Long Depression (1873-1896) is another example of a major depression that didn't end by getting involved in a war. I'm still skeptical.

~w
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Too late for a war - still fighting the one left over from from the lasst recession (and no one is going to get fired up about Afganastan)
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usually, they come up with a war on foreign soil to both distract the US citizens and also to boost the economy

I don't think the military would support that strategy now.
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