Our financial system was on the brink of a meltdown from counterparty risk associated with Credit Default Swaps when the Fed bailed out Bear Stearns. We still are on the brink and for the same reason. At that time, $45 TRILLION was the estimated notional value of CDS contracts. You would think that coming so close to a collapse would cause the people involved to slow things down or try to unwind this mess. But that has not happened. The most current estimate of notional CDS outstanding was $62 TRILLION. More dangerous - not less dangerous.

Listening to advocates of derivatives (and credit default swaps in particular) you’ll hear that they are good things and do a great job of spreading out risk. People in the industry making a ton of money with derivatives defend themselves and their livelihood as you would expect. Organizations such as the ISDA and its leader Robert Pickel will tell you that credit default swaps are greatly misunderstood by people like me.

Even Chairman Greenspan said how helpful derivatives and CDS are repeatedly during his tenure - just read through his speech to the Council on Foreign Relations in November 2002. Note that the CDS market’s notional value back then was about $2 TRILLION, a mere fraction of what it is today. In that speech, you’ll find some comments that should sound ridiculous based upon what we have learned in the past few months. Unless of course you make your money pushing this crap.

There are others trying to sound the warning like Yves and Barry and Mish. However, the financial media doesn’t seem to want to keep hammering on this. Instead, they just ask the simple questions and accept the simple answers and move on. As for the regulators - the CDS market is unregulated. But the closest we had were the Central Bankers. Assume Greenspan was the regulator - his mentality is what led to the giant mess we have today and that mentality still persists with sophisticated finance and economics gurus that have some control now. As for politicians and their ability to prevent a disaster with CDS contracts…that’s a joke.

Here are a few I selected from Greenspan’s speech:

As in all aspects of life, expansion of one’s activities beyond previously explored territory involves taking risks. And risk by its nature has carried, and always will carry with it, the possibility of adverse outcomes. Accordingly, for globalization to continue to foster expanding living standards, risk must be managed ever more effectively as the century unfolds.

The development of our paradigms for containing risk has emphasized dispersion of risk to those willing, and presumably able, to bear it. If risk is properly dispersed, shocks to the overall economic system will be better absorbed and less likely to create cascading failures that could threaten financial stability.

And later…..

The wide-ranging development of markets in securitized bank loans, credit card receivables, and commercial and residential mortgages has been a major contributor to the dispersion of risk in recent decades both domestically and internationally. These markets have tailored the risks associated with such assets to the preferences of a broader spectrum of investors.

Especially important in the United States have been the flexibility and the size of the secondary mortgage market. Since early 2000, this market has facilitated the large debt-financed extraction of home equity that, in turn, has been so critical in supporting consumer outlays in the United States throughout the recent period of cyclical stress. This market’s flexibility has been particularly enhanced by extensive use of interest rate swaps and options to hedge maturity mismatches and prepayment risk.

Financial derivatives, more generally, have grown at a phenomenal pace over the past fifteen years. Conceptual advances in pricing options and other complex financial products, along with improvements in computer and telecommunications technologies, have significantly lowered the costs of, and expanded the opportunities for, hedging risks that were not readily deflected in earlier decades. Moreover, the counterparty credit risk associated with the use of derivative instruments has been mitigated by legally enforceable netting and through the growing use of collateral agreements. These increasingly complex financial instruments have especially contributed, particularly over the past couple of stressful years, to the development of a far more flexible, efficient, and resilient financial system than existed just a quarter-century ago.

And later….

In decades past, such a sequence would have been a recipe for creating severe distress in the wider financial system. However, compared with decades past, banks now have significantly more capital with which to absorb shocks, and they employ improved systems for managing credit risk. In conjunction with this improvement, both as cause and effect, banks have more tools at their disposal with which to transfer credit risk and, in so doing, to disperse credit risk more broadly through the financial system. Some of these tools, such as loan syndications, loan sales, and pooled asset securitizations, are relatively straightforward and transparent. More recently, instruments that are more complex and less transparent–such as credit default swaps, collateralized debt obligations, and credit-linked notes–have been developed and their use has grown very rapidly in recent years. The result? Improved credit-risk management together with more and better risk-management tools appear to have significantly reduced loan concentrations in telecommunications and, indeed, other areas and the associated stress on banks and other financial institutions.

He went on to say a bunch of other positive things about Credit Default Swaps and derivatives in general before this prophetic warning….

More fundamentally, we should recognize that if we choose to enjoy the advantages of a system of leveraged financial intermediaries, the burden of managing risk in the financial system will not lie with the private sector alone. Leveraging always carries with it the remote possibility of a chain reaction, a cascading sequence of defaults that will culminate in financial implosion if it proceeds unchecked. Only a central bank, with its unlimited power to create money, can with a high probability thwart such a process before it becomes destructive. Hence, central banks have, of necessity, been drawn into becoming lenders of last resort.

But implicit in such a role is the assumption that the burden of risk arising from extreme outcomes will in some way be allocated between the public and private sectors. Thus, central banks are led to provide what essentially amounts to catastrophic financial insurance coverage. Such a public subsidy should be reserved for only the rarest of occasions. If the owners or managers of private financial institutions were to anticipate being propped up frequently by government support, it would only encourage reckless and irresponsible practices.

You really should read the whole thing before you make up your own mind. And then you might want to take a look at this Greenspan piece from May 5, 2005 - similar stuff with great praise for CDS and prescient warnings that went unheeded but interesting nonetheless. Just read everything you can from the supporters of credit default swaps like Robert Pickel. Let them convince you that they are smart and critics like me are stupid. Make sure you get settled on what you think is really going on here.

And then just when you have that figured out… whichever way you decide…ask yourself about settlement. “Settlement”?

I tried to get settlement information from the ISDA a month ago by sending them an email. I never really expected to see an answer so it wasn’t a surprise that I didn’t get one. But go ahead. Do your own investigation. Pretend like you are a “real journalist” and ask anyone that might have the information - how many times there have been actual settlements of CDS contracts when there was an event and what happened. Good luck finding any data much less comprehensive information. It’s an unregulated market so while you might want to know the open interest or volume or settlement - if someone has this data I think there is a good reason why it is not being shared.

Why is this important? Well, I think it’s important to know the negative and the positive consequences of anything that happens in life, not just the upfront price. And especially, I think it’s relevant to find all that out for something that could bring down our global financial system. Listening to CDS advocates - you are led to believe that they only have big benefits and the possible negative effects are minimal. Don’t you want to know what you are getting out of this CDS “risk management system” to offset what might cause a meltdown?

One of the things that has me unsettled is that CDS contracts supposedly protect against a credit event in the referenced entity - but how often has that happened?

Isn’t it relevant to know how much “protection” there is against an individual referenced entity even if that means it is 10 times the corporation’s debt?

Isn’t it relevant to know exactly how many dollars of defaulted bonds have been recovered by the “insurance” that a CDS provides?

Isn’t it relevant to know whether there was physical or cash settlement?

Isn’t it relevant to know whether the settlement specified in the contract had to be “fixed” when there was a problem like Delphi’s auction mechanism?

Isn’t it relevant to know how many settlement claims are being litigated to avoid payout?

Corporate defaults have been very low for years. So what risk was being hedged? For all the money that has been made and lost on the CDS market which now totals over $62 TRILLION - how much of that has come from trading and covering bets and how much has come from actual payouts from the outcomes supposedly being hedged?

When Countrywide was on the brink of bankruptcy before the Bank Of America bailout, there was a risk of seeing what would happen to all those Countrywide CDS contracts. We never found out did we? When the Monoline Insurers MBIA and Ambac and ACA were about to test the CDS settlement mechanisms, everything possible was done to just avoid it. Bear Stearns almost gave us a test of the counterparty risk and we were prevented from finding out what would happen.

I look at the CDS market like betting / speculating on the outcome of a sporting event but where the window never closes and the final outcome is never disclosed.

People are making money and losing money along the way but this is not a zero sum game. Sooner or later, we will find out what happens when risk dispersion meets the settlement.