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

Tom Segev at 80: Why One of Israel’s Leading Historians Now Calls Zionism a Mistake. Haaretz. Analysis and Summary. Haaretz

                Tom Segev. Looking Back, Israeli Historian Tom Segev Thinks Zionism Was a Mistake April 4, 2025 — By Ofer Aderet (Analysis and Summary) Haaretz  Israeli historian Tom Segev , long known for his critical lens on the history of Israel and Zionism , has made perhaps his boldest statement yet. At the age of 80, Segev reflects on his personal journey and the historical myths that shaped both his family narrative and the nation’s identity. His revelations , detailed in an in-depth Haaretz article, offer not just a personal reckoning but a broader challenge to Zionism’s moral and historical foundation . Key Themes and Analysis 1. Personal Revelation and Historical Reckoning Segev opens his reflection by confronting a deeply personal myth : the circumstances of his father’s death during the 1948 Arab-Israeli War. For decades, he believed the official narrative that his father, Heinz Schwerin, was killed heroically...

The Hunger Crisis in Gaza: A Deadly Cycle of Starvation, Suffering, and Refeeding Syndrome

As the siege on Gaza continues to devastate millions, the world watches as a catastrophe unfolds — one of the most heart-wrenching humanitarian crises in recent history . The simple act of eating has become a life-or-death decision for thousands of Gazans, as they struggle to survive on dwindling supplies of food and water. The situation is dire. According to recent reports from The New York Times , nearly 91% of Gaza's population is now facing “food insecurity,” with many enduring “emergency” or “catastrophic” levels of hunger. Bakeries have shut down , and charity kitchens are overcrowded as people wait for a meager meal. The UN has raised alarms that Gaza may already be on the brink of famine , with children showing the visible signs of malnutrition — emaciated bodies, hollow eyes, and weakened immune systems. But the horror doesn’t end with hunger. As Gaza’s population survives on less and less, the collapse of the healthcare system has created a terrifying new danger:...

Turning Lifelines into Leverage: Israel’s Plan to Control Aid in Gaza Sparks Global Outcry

For over two months, Israel has restricted aid access into Gaza —a territory already reeling from massive displacement, bombings, and near-famine conditions. Now, a new plan by Israeli authorities to control aid delivery has sparked outrage from the United Nations and international NGOs. 1. What Is Israel Proposing? Israel wants to create military-controlled “hubs” within Gaza where international aid can be distributed. Under this plan, private contractors would manage the flow of food, medicine, and water—under supervision of Israeli forces. 2. Why Are Aid Groups Refusing? Humanitarian organizations argue that this proposal violates principles of neutrality. They believe it turns life-saving aid into a political tool, essentially using humanitarian support to pressure Hamas and control civilians. “It contravenes fundamental humanitarian principles,” said the United Nations in a joint statement with aid groups. 3. Mass Displacement and Humanitarian Zones As part of its comi...

From “Hamas Looked at Me Wrong” to “An Israeli Raped Me”: The Curious Case of Mia Schem’s Shifting Headlines

Ah, Mia Schem . The face of hostage survival , the darling of Israeli media, and, apparently, the victim of just about everyone — depending on which week it is. Let’s rewind . Back in late 2023, Mia was abducted by Hamas during the infamous October 7 Nova music festival attack . Tragic? Absolutely. No one in their right mind would wish such trauma on another human being . She was held for 54 days , wounded, and later released as part of a hostage exchange . S he became a symbol — paraded across global media as proof of Hamas’s inhumanity. In one bizarre interview with Western outlets, she suggested that while in captivity, Hamas fighters “raped her with their eyes.” That’s right. No physical assault reported , no formal accusation — just a poetic kind of violation . A stretch? Many thought so. But hey, nuance was out, and propaganda was in . Fast forward to March 2025. In a surprising twist of narrative, Mia filed a police complaint — not against Hamas , not against some lurking ter...

Zionism and Post-Holocaust Christian Theology: A Jewish Perspective. Mark Braverman

     Introduction of Mark Braverman: Mark Braverman is a Jewish-American psychologist, theologian , and prominent voice in the interfaith justice movement for Palestine . Raised in a strong Zionist tradition , Braverman underwent a personal and moral transformation after witnessing the realities of the Israeli occupation . He is the Executive Director of Kairos USA , an organization that mobilizes American Christians to support Palestinian rights. Braverman focuses on the intersection of theology, justice, and the Israeli-Palestinian conflict. His work critiques both Jewish and Christian theological frameworks that support Zionism and calls for a prophetic response rooted in human rights and reconciliation. His major works include Fatal Embrace: Christians, Jews, and the Search for Peace in the Holy Land and numerous essays on interfaith theology and justice. Mark Braverman. Opening Note: In the wake of the Holocaust , Christian theology took a new direction — see...