Common Sense Living

Financial Weapons of Mass Destruction: Credit Default Swaps

What if you could get paid billions of dollars to DESTROY companies, instead of building them?  After all, it is much easier to kill a company and run it out of business than it is to make one successful and profitable.

It just so happens that our dear “friends” on Wall Street invented the tools to do just that, and in 1994 created a derivative called a “credit default swap”, or CDS.

Warren Buffett had a simpler and more truthful name, a “financial weapon of mass destruction.”

creditdefaultswaps

WHAT IS A “CREDIT DEFAULT SWAP” (CDS)?

In a nutshell, a CDS is an insurance policy.  You are insuring that a stream of payments, perhaps on money you lent to someone, will be paid.  If the borrower fails to pay you, you collect on the insurance policy instead.

In some respects, Private Mortgage Insurance (or PMI) can be considered a form of credit default swap.  If you default on your mortgage, the insurance agency you bought the PMI through pays off your mortgage to the lender.  Lenders often require this insurance if your mortgage exceeds 80% of the value of your home.

WHAT MAKES CDS’s DIFFERENT?

In the PMI example above, you have an interest in making sure the lender is kept whole, as you are the borrower.  The lender also has an interest in getting their loan repaid.

A CDS is different in that NEITHER the borrower, nor the lender needs to have an interest in the loan being insured!!  For example, I can agree to pay you $100/month for $50,000 of insurance on the mortgage of your neighbor.  If your neighbor defaults on his mortgage loan, you would owe me the $50,000 per our insurance contract.  Your neighbor may not even know of our contract!

This is a RADICAL departure of normal insurance rules!  For me to take out fire insurance on your neighbor’s home, I have to either own the home, or I have to have some other interest in the home perhaps as a lender on the home loan.

CDS’s however don’t follow insurance rules because they are not governed by State insurance regulators.  Instead, they are overseen (“regulation” is too strong a term) by the Securities and Exchange Commission (SEC) where for all practical purposes there is NO regulation.

PUBLIC POLICY PROBLEM #1:  WALL STREET IS SELLING INSURANCE THAT IS NOT REGULATED BY ANY QUALIFIED INSURANCE REGULATORY AGENCY!

Another “feature” of CDS’s is that there is no limit to the amount of insurance that can be purchased for a single loan.  With normal fire insurance, I can only insure a home up to its replacement value.  I cannot insure my car for more than it’s worth.  If the regulators allowed me to have $1 Billion of fire insurance on my home, a HUGE incentive would exist for me to burn the home down!

With a CDS, I can insure your neighbor’s mortgage for as much as $1 Billion!  Doesn’t that incentivize me to encourage your neighbor to NOT pay his mortgage bill?  I would encourage him/her to smoke, drive fast, or gamble……anything to have him default on his bills.

HOW TO USE CDS’s TO GET RICH DESTROYING COMPANIES (THE WALL STREET WAY)?

First, you and I stand little chance to get rich destroying companies.  However, predatory Private Equity firms ARE big and savvy enough to use these tools as weapons of mass destruction, and get very rich in the process.

Suppose you are a private equity firm, and you just borrowed $1 billion from your investment bank (Goldman Sachs, Morgan Stanley, etc.) to acquire a target company.

After acquiring a controlling interest of the target company, here is the procedure you would now use…..

STEP 1: Fire all expensive employees.  Sell all real estate, and lease back the offices.  Stop buying pencils.  Let the computers get old.  Cancel all support agreements.  Combine offices to save on costs.  Overwork the employees.  Do ANYTHING that will cut costs and save a dollar now.  You don’t care about the future company, as you are going to kill it for a massive profit!  Now your cash flow looks great almost immediately.  You, the new owner, are looking like a genius!

STEP 2:  Tell your CEO and CFO to go to their commercial banks, and borrow every penny they can based on the remaining assets of the company, and the now increased cash flow.  So they go borrow $1.1 billion.  You now own a company with very high debt, and a lot of cash.

STEP 3:  You now want to insure that massive debt on the company you own.  So you go to AIG and create a CDS, taking out $500 million of credit default insurance (paying a monthly fee to AIG).  AIG sees you as the owner, and thinks of all folks, you want the company to succeed.  Truth is, you don’t.  You instead make a similar $500 million deal with Citigroup, with Deutsche Bank, with Bank of America, with Prudential, with Merrill Lynch, and any other sucker you can find to insure that debt yet again.  In this case, you now have $3 billion of insurance on a $1.1 billion loan.

STEP 4:  After the insurance is in place, you instruct the CEO and CFO to pay a 1-time dividend of $1.1 billion to the shareholders (i.e. you).  You then use $1 billion of that dividend money to pay off your loan from the investment bank.  Now the company you bought owes money, but you don’t.  They are on the hook, not you.

 PUBLIC POLICY PROBLEM #2:  PRIVATE EQUITY FIRMS ARE ABLE TO SHIFT THEIR OWN INVESTMENT BANKING DEBT FROM INVESTMENT BANKS TO COMPANY DEBT HELD BY COMMERCIAL BANKS, WHERE TAXPAYERS GET STUCK BAILING OUT THE COMMERCIAL BANKING LOSSES!!

STEP 5:  Now all you do tell the CEO to keep cutting costs, and squeezing every penny out of the company you bought.  When the company fails, you will collect $3 billion on your credit default swaps.  Everyone will pity you as the owner, who appears to have lost your original $1 billion investment.  Truth is, you just profited $1 billion in 1-time dividends, and $3 billion on CDS insurance!

And you did all this by killing the company, squeezing the costs until it suffocated!

WHAT WILL THE NEWS SAY?

Take a look at these links and tell me if this looks like what happened in these cases?  Of course, we will never know for sure unless Congress does an investigation and seizes records!!!

Sealy Shareholder Rips Buyout Owner KKR

Sealy basically failed, and was later merged with Serta.

Toys ‘R’ US Strange Silence Forced Its Bankruptcy

Toys R Us went out of business this year, and KKR “claimed” to have lost roughly $400 million on the deal.  Who really knows what happened??  Clearly here, JP Morgan had their investment insured with CDS’s!

Speculative-Grade Companies Increase Borrowings to Finance Dividend Payments

WHY ARE CDS’s SO DANGEROUS?

Even though introduced in 1994, the purchase and issuance of CDS’s are now a MASSIVE industry.  They are unregulated, and there is virtually no tracking of these weapons!

It is estimated that there is as much as $250 TRILLION of CDS’s in existence, meaning that when a debt defaults, many times that debt will be claimed in the form of insurance.

If the economy, which is loaded heavily with debt, begins to waver, and credit defaults become more common, there will be a MASSIVE wave of CDS claims on that insured debt.

The companies that provide this insurance in the form of CDS’s will not have that kind of money.  It will be like a financial natural disaster taking out half the world!  Except there is nothing natural about this.

The use of credit default swaps should be outlawed (again), or at a bare minimum, they should fall under similar regulation as other normal insurance contracts.  Nobody should be rewarded for destroying their own property, even if it is a business.  Especially when 30,000 are put into the unemployment lines as result!

 

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