The $50 to $70 Trillion dollar Black Hole – Credit Default Swaps

Nouriel Roubini is an NYU economics professor who predicted the financial sub prime mortgage crisis way back in 2006. His web site LINK is rated the #1 economics web site in the world by The Economist.

Roubini thinks we now are taking the right action but firmly holds to his prediction of "a recession that lasts as long as 24 months, with unemployment reaching 9% and depressed home prices falling another 15%. " The total credit loss from the subprime mortgage mess will be "closer to $3 trillion" rather than the $1.4 trillion the already discredited (they keep jacking up their figures) of the International Monetary Fund (IMF)

Most on the CNBC the financial channel that cheerleads for the markets think things won’t get so bad, but there are a few others out there who think they’ll get a whole lot worse than Roubini’s forecast.

What are Credit Default Swaps (CDS)

Simply they are totally unregulated insurance policies or bets put on financial instruments like credit cards, home loans, student loans, equity lines of credit, and other stuff like subprime mortgages. No one really knows how big this CDS market is because it is unregulated but most estimates come in at $50 to 70 trillion. Context – That’s bigger than the entire world’s GDP last year, about 5 times bigger than the US GDP and several times bigger than all the equity in US stocks

The best explanation out there on CDS that’s simple, graphic and takes less than a minute to skim was in the NYT LINK

Two important facts

1) instead of calling this credit default insurance, they called it "swaps" so that it would not fall under the regulations of the insurance industry.
2) as the NYT chart shows there were a whole line of dominoes (bettors) who kept assigning the insurance contract (CDS) to another party (bettor)

Who Started the CDS Catastrophe?

Last week Updates went over why we should look in the mirror when it comes to credit. Now let’s get more specific.

CDS’s were the political brainchild of Republican Senator Phil Graham (Ironically the man McCain choose as his chief economic advisor) Graham led the deregulation effort which cumulated in the 2000 Commodities Future Modernization Act. Fed Chair Alan Greenspan endorsed the move and fought bitterly against any attempt to regulate markets and thus his reputation offered protection for Republicans and many Democrats who supported deregulation and CDS.

This all came out of those who worship economist Milton Freedman and took his concept of non intervention in free markets to its extreme. It started with Ronald Reagan who claimed government is the problem not the solution (at the time government was creating problems) and every President including Clinton to George Bush #2 followed this course. Free markets do work better than socialism, but obviously NO regulations/government intervention has created a $50 to 70 trillion dollar black hole.

Whose to Blame

The small part of the unregulated CDS market that collapsed was subprime mortgages. Greenspan and the Fed left interest rates far too low for far too long (Bernanke deserves a small part of the blame here too) You know this story – predatory lenders, people getting in over their heads, house flippers etc. At the hight of this subprime mess in 2006 most of the lenders were private companies (@85%) and some were public – Fanny and Freddie (@15%) LINK

All these lenders share some blame, but its what happens next that caused the meltdown. All 5 of the Investment Banks, Insurance companies (AIG), Hedge Funds, Conglomerates, Banks & Financial Institutions across the world resold and resold and resold and resold and resold all this insurance (CDS) further diluting the assets that backed up the original loan. Moody’s and Standard and Poors (major bond rating agencies) also guaranteed lots of these unregulated bonds

So when the first Bear Stern’s hedge fund could not meet its insurance (swap) obligation because it had something like $1 in collateral for $100 invested (I’m guessing) the snowball started to roll down hill.

What’s next

The unregulated $50 to $70 Trillion dollar CDS market is buying and selling today. You’d think they would be a bit more cautious now. They are because the credit markets all over the world are almost at a virtual halt. We the taxpayers have put up $700 billion to fix the $70 trillion still existing CDS market. $700 billion does seem like chicken feed up against 70 trillion.

Let’s say Roubini’s 24 month recession comes to pass and home prices fall another 15% and unemployment reaches 9%. Will CDS’s on credit cards collapse? How much bigger will the subprime mess be? Will home equity, car loans, and student loans follow subprime? Countries could default on their CDS obligations (Iceland’s banks already have this problem – Ton Friedman in NYT on this LINK )

Hell, one solution is to cancel all outstanding CDS’s. Of course this would set off an immediate worldwide depression.

Bottom Line -

If Roubini 24 month recession comes to pass there is NO way the stock market is going to move higher. In fact you could see some might big falls. Many stock market analysts look about 6 months into the future to set price and 24 months is a long time. Few Joe’s and Jane’s in the USA understand the $50 to 70 Trillion dollar black hole hanging over our heads. That’s $200,000 for every man woman and child in the USA.

Best Read of The Tea Leaves. – Two long term paths

1) CNBC and Warren Buffett say buy now. The trouble here is CNBC (the financial channel) is a cheerleader for their advertisers (the markets) and Warren Buffett as well meaning as he is gets these phenomenal guarantees when he buys stocks.

2) Roubini 24 month recession or worse. This would mean more of the $70 trillion of uncollateralized debt (CDS’s) will rain down on us.

Going out on a limb – If you are out of the markets nibble a little and get back on dips – the bigger the better. I would also suggest sometimes selling into big rallies. If you are still 100% invested in the markets I’d sell some into the rallies.

As Updates has pointed out last week there has been a very small move in the right direction in credit markets recently and this should help stocks rally this week. We will get through this crisis, but its now looking like its going to take a few years.

Skipping right to Long Term Outlook going back to bed and pulling covers over my head because the Red Sox’s lost.

AS ALWAYS DO YOUR RESEARCH BEFORE INVESTING

Long Term Outlook – Cautiously Bearish

Technicals – Double bottom has formed, advance in strong , increased volume, and a new high on VIX -Technically all this = at least a short term rally and maybe a long term bottom.
Fundamentals – financial mortgage transparency problem is far far far far far far far far far bigger than anyone thought. New worldwide rescue plan offers hope, but this rally is going to be a bumpy ride because retail investors trust has been shaken. Global growth is obviously slowing

People feel like we are in a recession. The actual strict definition – 2 quarters of negative GDP growth has not occurred. How bad the recession will be is be is the major question. It’s beginning to look like the recession might last through 2009 – perhaps longer

Asset Allocation/Recommended Sectors (long term)

* 80% to 100% Cash – This depends on your risk tolerance

* 10% US Index Funds
UWM (ETF that does 2x what Russell 2000 does) & QLD (ETF that does 2X what the NASDQ does) DDM (ETF that does 2X what the Dow does)
*5% Emerging Markets
EWZ (Brazil) should out perform other emerging markets in a rally and under perform in a fall – highest risk
*5% Alternative Energy
GEX(Alternative energy ETF) (If Obama wins you will see this sector flourish)

Chief Strategy – Buy the DIPS of trending sector – This is not your fathers market- over the 8 Bush years the Dow has gone from 11,000 to 8,500 and uncertainty clouds the future. The major trend is volatility.

Traders who have a strong tolerance for risk jump in on dips and invest more. Sell or go short into major rallies. Long term Investors who can tolerate risk and are 100% in cash nibble just a little on dips. Do not buy into rallies.

Shorting – Three ETF that do 2x what the the major indexes do -
TWM – ultra short Russell 2000
QID – ultra short NASDQ
SDS – ultra short S&P 500

Changes to Bottom Line Section Bolded

As Always Do Your Own Research Before Investing

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