Skip to main content

The Real Reason Behind the Global Financial Crisis

by: Money Morning posted on: September 19, 2008
By Shah Gilani
[Part I of a three-part series looking at how so-called “credit default swap” derivatives could ignite a worldwide capital markets meltdown]
Are you shell-shocked? Are you wondering what’s really going on in the market? The truth is probably more frightening than even your worst fears. And yet, you won’t hear about it anywhere else because “they” can’t tell you. “They” are the U.S. Federal Reserve and the U.S. Treasury Department, and they can’t tell you what’s really going on because there’s nothing they can do about it, except what they’ve been trying to do - add liquidity.
At the exchange rate Wednesday, 35 trillion British Pounds was equivalent to U.S. $62 trillion (hence, the 35 trillion pound gorilla). According to the International Swaps and Derivatives Association, $62 trillion is the notional value of credit default swaps [CDS] out there, somewhere, in the market.
This isn’t the first time Money Morning has warned readers about the dangers of credit default swaps. And it won’t be the last.
The Genesis of a Derivative Boom
In the mid-1980s, upon arriving in New York from Chicago with an extensive background in trading options and futures (the original derivatives), I was offered a job at what was then Citicorp [today’s Citigroup Inc. (C)]. The offer was for an entry-level post in the bank’s brand new OTC (over-the-counter, meaning not exchange traded) swaps and derivatives group. When I asked what the economic purpose of swaps was, the answer came back: “To make money for the bank.”
I declined the position.
It used to be that regulators and legislators demanded theoretical, empirical, and quantitative measures of the efficacy of new tradable instruments being proposed by exchanges. What is their purpose? How will they benefit the capital markets and the economy? And, what safeguards will accompany their introduction?
Not any more. In the early 1990s, in order to hedge their loan risks, J. P. Morgan & Co. [now JPMorgan Chase & Co. (JPM)] bankers devised credit default swaps.
A credit default swap is, essentially, an insurance contract between a protection buyer and a protection seller covering a corporation’s, or sovereign’s (the “referenced entity”), specific bond or loan.
A protection buyer pays an upfront amount and yearly premiums to the protection seller to cover any loss on the face amount of the referenced bond or loan. Typically, the insurance is for five years.
Credit default swaps are bilateral contracts, meaning they are private contracts between two parties. CDSs are subject only to the collateral and margin agreed to by contract. They are traded over-the-counter, usually by telephone. They are subject to re-sale to another party willing to enter into another contract. Most frighteningly, credit default swaps are subject to “counterparty risk.”
If the party providing the insurance protection - once it has collected its upfront payment and premiums - doesn’t have the money to pay the insured buyer in the case of a default event affecting the referenced bond or loan (think hedge funds), or if the “insurer” goes bankrupt (Bear Stearns was almost there, and American International Group Inc. (AIG) was almost there) the buyer is not covered - period. The premium payments are gone, as is the insurance against default.
Credit default swaps are not standardized instruments. In fact, they technically aren’t true securities in the classic sense of the word in that they’re not transparent, aren’t traded on any exchange, aren’t subject to present securities laws, and aren’t regulated. They are, however, at risk - all $62 trillion (the best guess by the ISDA) of them.
Fundamentally, this kind of derivative serves a real purpose - as a hedging device. The actual holders, or creditors, of outstanding corporate or sovereign loans and bonds might seek insurance to guarantee that the debts they are owed are repaid. That’s the economic purpose of insurance.
What happened, however, is that risk speculators who wanted exposure to certain asset classes, various bonds and loans, or security pools such as residential and commercial mortgage-backed securities (yes, those same subprime mortgage-backed securities that you’ve been reading about), but didn’t actually own the underlying credits, now had a means by which to speculate on them.
If you think XYZ Corp. is in trouble, and won’t be able to pay back its bondholders, you can speculate by buying, and paying premiums for, credit default swaps on their bonds, which will pay you the full face amount of the bonds if they do actually default. If, on the other hand, you think that XYZ Corp. is doing just fine, and its bonds are as good as gold, you can offer insurance to a fellow speculator, who holds the opinion opposite yours. That means you’d essentially be speculating that the bonds would not default. You’re hoping that you’ll collect, and keep, all the premiums, and never have to pay off on the insurance. It’s pure speculation.
Credit default swaps are not unlike me being able to insure your house, not with you, but with someone else entirely not connected to your house, so that if your house is washed away in the next hurricane I get paid its value. I’m speculating on an event. I’m making a bet.
The bad news is that there are even worse bets out there. There are credit default swaps written on subprime mortgage securities. It’s bad enough that these subprime mortgage pools that banks, investment banks, insurance companies, hedge funds and others bought were over-rated and ended up falling precipitously in value as foreclosures mounted on the underlying mortgages in the pools.
What’s even worse, however, is that speculators sold and bought trillions of dollars of insurance that these pools would, or wouldn’t, default! The sellers of this insurance (AIG is one example) are getting killed as defaults continue to rise with no end in sight.
And this is only where the story begins.
The Ticking Time Bomb
What is happening in both the stock and credit markets is a direct result of what’s playing out in the CDS market. The Fed could not let Bear Stearns enter bankruptcy because - and only because - the trillions of dollars of credit default swaps on its books would be wiped out. All the banks and institutions that had insurance written by Bear would not be able to say that they were insured or hedged anymore and they would have to write-down billions and billions of dollars in losses that they’ve been carrying at higher values because they could say that they were insured for those losses.
The counterparty risk that all Bear’s trading partners were exposed to was so far and wide, and so deep, that if Bear was to enter bankruptcy it would take years to sort out the risk and losses. That was an untenable option.
The Fed had to bail out Bear Stearns.
The same thing has just happened to AIG. Make no mistake about it, there’s nothing wrong with AIG’s insurance subsidiaries - absolutely nothing. In fact, the Fed just made the best trade in its history by bailing AIG out and getting equity, warrants and charging the insurance giant seven points over the benchmark London Interbank Offered Rate [LIBOR] on that $85 billion loan!
What happened to AIG is simple: AIG got greedy. AIG, as of June 30, had written $441 billion worth of swaps on corporate bonds, and worse, mortgage-backed securities. As the value of these insured-referenced entities fell, AIG had massive write-downs and additionally had to post more collateral. And when its ratings were downgraded on Monday evening, the company had to post even more collateral, which it didn’t have.
In short, what happened in one small AIG corporate subsidiary blew apart the largest insurance company in the world.
But there’s more - a lot more. These instruments are causing many of the massive write-downs at banks, investment banks and insurance companies. Knowing what all this means for hedge funds, the credit markets and the stock market is the key to understanding where this might end and how.
The rest of the story will be illuminated in the next two installments. Next up: An examination of the AIG collapse, followed by a look at how bad things could get, and what we can do to fix the problem at hand. So stay tuned.
Original post

Comments

Popular posts from this blog

Delivering the Dead: How the World Watches Gaza Bleed.

  Delivering the Dead: How the World Watches Gaza Bleed “ I delivered a beheaded woman who was nine months pregnant. ” That’s not a horror-film script. That’s not medieval history. That is the testimony of an Australian medic standing in a Gaza hospital in 2025, describing what it means to “ practice medicine ” under Israeli bombardment. A nine-months-pregnant woman , decapitated , her body torn open so that the child she carried could be pulled out lifeless — and somehow this is still not enough to shake the comfortable democracies of the West into anything resembling a conscience. We should probably give the Nobel Prize for Creative Euphemism to the politicians who still call this “self-defense.” After all, there’s nothing quite as defensive as severing the head of an expectant mother and forcing foreign doctors to deliver her dead child in the rubble of what used to be a hospital . Bravo, civilization . The tragedy is not just the atrocity itself. It’s the smug perfo...

Britain’s Recognition of Palestine: A Century of Complicity in Disguise.

So we’ve reached this moment: Keir Starmer’s UK “ recognises the State of Palestine. ” Applause lines up. Speeches made. Headlines dazzled. But behind the pomp, the guns, the exports, the intelligence, the training — history rings out in mocking laughter. Because Britain has been complicit since day one. This recognition is not redemption . It’s theatre. 1. The Original Sin: Balfour Declaration Let’s go back. Because if you don’t know your history, you’ll be fooled by the future. On 2 November 1917 , Arthur James Balfour (Britain’s Foreign Secretary) wrote to Lord Rothschild, and officially declared: “His Majesty’s Government view with favour the establishment in Palestine of a national home for the Jewish people, and will use their best endeavours to facilitate the achievement of this object , it being clearly understood that nothing shall be done which may prejudice the civil and religious rights of existing non-Jewish communities in Palestine , or the rights and political sta...

Gaza’s Medical Apocalypse: Numbers, Neglect, and the Farce of “Access”

  If you ever needed proof that statistics can be more damning than bombs, look at Gaza’s health crisis . Behind the headlines and hashtags lies a cascade of bodies and broken systems. We have numbers, we have reports, we have PDFs— and yet the world stares, unmoved, at the collapse. Below is your ruthless, numbers-soaked guide to the suffering —and the institutional failure—behind Gaza’s medical implosion . 1. The Health System Is Already Dead. We’re Just Counting the Corpse. According to WHO, “The Gaza Strip faces an unprecedented humanitarian crisis with rising mortality and widespread displacement.” Between 1 January and 31 August 2024 , local health authorities reported 18,900 deaths and 38,916 injuries . Women, children, and the elderly account for over 50 % of fatal casualties . More than 53 % of Gaza’s 36 hospitals were non-functional as of August 2024, and many of the partially functioning ones lacked adequate water or relied entirely on fuel generators. ...

The Ceasefire of Exhaustion: When Empires Collapse from Within

  By Malik Mukhtar — ainnbeen.blogspot.com Two years after Gaza was first set on fire , the war that began with biblical vengeance has stumbled to an exhausted ceasefire . On October 9, 2025 , Israel and Hamas — after endless carnage, famine, and rubble — have signed the first phase of a ceasefire agreement mediated in Sharm el-Sheikh . Trump called it a “ historic peace plan. ” History may call it a truce of attrition — a war that collapsed under the weight of its own hubris. What the Ceasefire Says — and What It Doesn’t Under the agreement, Israeli forces are to pull back to a designated “yellow line” within 24 hours of cabinet ratification. Hamas, in turn, will release all remaining hostages — alive or dead — within 72 hours after the withdrawal. Israel will free about 2,000 Palestinian prisoners, though it made sure to exclude political figures like Marwan Barghouti , whose freedom would remind the world that Palestine still breathes. Humanitarian convoys — food,...

The End of Zionism? Welcome to the Funeral Nobody Wants to Admit Is Overdue

  Of course. Haaretz recently published an opinion piece by Ithamar Handelman -Smith titled “ Some Say It’s the End of Zionism, and I Say That’s All Right .” And what impeccable timing: as Israel carries out a near-two-year campaign of siege, famine, and bombardment in Gaza — slaughtering families, burying aid workers with their ambulances, and literally starving children to death — someone in Israel finally whispers the unspeakable: maybe Zionism, that 20th-century project of “ Jewish salvation ,” has outlived its moral shelf life. Bravo. The house is burning, bodies are scattered in the street, and the philosopher shows up with a garden hose . Zionism: Success Story or Crime Scene? Handelman-Smith argues that Zionism achieved its success : a Jewish state, a safe haven, a fortress against the ghosts of Europe’s crimes . But like every “ success story ” drenched in other people’s blood , it didn’t age well. What began as refuge turned into domination; what was called “ ...