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The top 25 investment banks have a notional derivatives exposure of $700 trillion, more than ten times the GDP of the Earth. While I'm almost invariably optimistic, this cannot end well, and it's likely to end very badly in 2012 -- and in my opinion probably worse than 2008.

How did this happen? I mean, by now we all pretty much know how the housing bust of 2008 happened. Banks sold high-risk loans, and then collected them into securities called Collateralized Debt Obligations (CDOs), which they sold to investors. Due to the number of mortgages gathered, there was no way they could fail to pay out unless the entire housing market collapsed at once, so they were rated AAA. Since they were rated AAA, banks and investors could own them as "risk-free" investments, increasing their leverage. Everything was going swimmingly until the "black swan" event happened -- the entire housing market declined at once, causing CDOs to fall below par value. As soon as they fell below par value, it triggered credit default swaps, AIG went bankrupt, and banks started failing. Chaos ensues.

Amazingly, the banks have contrived to make it all happen again, only bigger this time.

A digression for a moment: what is a Credit-Default Swap (CDS)? A credit-default swap, at its core, is a hedge -- a type of insurance. Say I own $1M of French bonds, but I'm worried that maybe France might not pay its debts -- that is, by owning a bond (or, in the housing bust case, a CDO), I have a default risk -- the risk I may not get paid back. So I can go to an investment bank or insurance company (like AIG), and ask them to write me a credit-default swap on $1M of French bonds. They will quote me a price, say $18,725 for five years. If my French bonds fail to pay out their full value of $1M within 5 years, the insurance company will pay me the difference. Thus, I no longer bear default risk -- I have sold my default risk to someone else by paying $18,725. (Incidentally, this really is the price of a $1M French CDS as I write this post.)

The first interesting part here is that the bank or insurance company that writes the CDS does not have to set aside $1M. It's like regular insurance -- they don't have to be able to pay every single policy holder the maximum amount of their policy at the same exact moment, as this would be absurd and no insurance would exist. However, in this case, French bonds (the asset I'm insuring) are AAA-rated (yes, by the same ratings agencies that rated subprime housing CDOs AAA), and thus considered "risk-free." The bank or insurance company thus can set aside almost nothing to cover this CDS; they can write CDSs for vastly more money than they have.

Modern banks are hackers. They no longer make money the way they did in the 90's and before, off of fees -- taking a small, fixed percentage of many large transactions. Instead, they've found a different tactic: exploiting. Not in the "they're exploiting the workers!" sense, but in the computer-hacking sense: they look at a system, see where the system's internal interactions make bad assumptions, and then push against those to create the result they want. Goldman Sachs gave us a fantastic example of an exploit back in 2008: they gathered the worst mortgages they could find -- the ones most likely to fail -- into a CDO, then marketed and sold it to their own retail brokerage customers. And then for ultimate chutzpah, they borrowed those same securities back (with the loan denominated in shares, not dollars), sold them to their customers again, and then repaid the loan after the housing bust in now-worthless shares. That's not an investment, that's an exploit -- they sold bad debt they knew was bad twice to the same people, without taking any of the cost themselves. (No one went to jail for this scam.)

Here's the new exploit: naked credit-default swaps. A naked credit default swap is simply purchasing a credit-default swap on an asset that you do not actually own. At first this doesn't seem too crazy -- it's like buying a life insurance policy on somebody else. But consider the consequences: if I buy a credit-default swap on $1M of French debt without actually owning any French debt, I've paid $18,725 for somebody to owe me up to $1M if France defaults.

This is not a hedge. This is not an investment. This is a bet. It's no different than going to a bookie and saying "will you give me 53-to-1 odds on France to lose?" It's flat-out gambling -- the Wall Street Casino has genuinely become a casino -- only since it's disguised as a derivative, it's legal. And just like that bookie, the banks or insurance companies they're buying from don't actually have enough money to pay everybody at once -- they're relying on the fact that they'll win some and lose some.

I've used French bonds as my example here, and there's a reason for that. After the collapse of the housing market, banks needed something else to invest in and speculate on -- residential CDOs weren't selling anymore. So they settled on something stable, something safe, something no one could complain about -- sovereign debt. A lot of it is European sovereign debt -- that same debt we've been hearing about in all these "European debt crisis" news stories. You can buy a CDS on French debt for 187.25 basis points ($18,725 for a million dollars in debt.) Greek CDSs are going to run you 9949.1699 basis points -- i.e. insuring a million dollars in Greek bonds will cost $994,917, because the people writing CDOs consider them more or less certain to default.

But only a couple years ago, Greek sovereign debt was "safe" -- highly rated, risk free. People writing these CDSs now considered more or less certain to default didn't have to set aside much capital to cover them at all. Of course, it's not like every European country is really going to default at once -- though I wouldn't rule out Greece, Italy, and Spain all doing so in rapid succession. But it turns out that they don't have to.

Leverage ratios (the ratio of potential debt to total equity) on the top 25 banks are incredibly high -- and when you're leveraged 25-to-1 a loss of 4% on your capital wipes out all equity, which means you're bankrupt. They don't have to lose everything to lose everything -- even (relatively) small losses can result in bankruptcy.

Who sold these guys all these CDSs anyway? AIG went bankrupt and had to be bailed out in the housing crisis, so who's the bigger fool? There are two answers, and both are shocking. The first is that AIG itself is once again one of the largest writers of credit-default swaps, so if Europe implodes U.S. taxpayers will get to bail them out again. The second is that the big banks write CDSs to each other. Consider the amazing result: banks have combined gambling with counterfeiting. Goldman Sachs goes to Citigroup and pays $20k to buy a $1M liability. Citigroup goes to Bank of America and uses that $20k to buy two more $1M liabilities. Bank of America goes to another bank, and the cycle repeats. Each bank owes all the others more money than it has. This is how banks with $15 billion in assets get a notional derivatives exposure (i.e. the maximum they could theoretically owe if every investment went bad at once) of $700 trillion. Of course they won't have to pay all of that at once -- but they only have to be hit with a tiny fraction of it to go bankrupt. The fact that everyone else will owe them at the same time will do almost no good -- a bank that can't pay now is bankrupt, no matter what its receivables (from other equally-bankrupt entities) may be.

This is a secular deleveraging cycle, which we haven't seen since the Great Depression. The only way out is through, and it won't be pretty for a while.


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