The Credit Default Swap Moral Hazard And Top Five US Banks

Warren Buffett has described derivatives “as weapons of mass destruction.”   Credit default swaps are portrayed as financial arrangements too difficult for the unsophisticated to understand.   Credit default swaps are a type of derivative held mostly by the top five too-big-to-fail US Banks.  Are credit defaults a moral hazard for US banks, because they allow earnings now and possibly very large leveraged losses later?  “Trading” losses at JPMorgan Chase of $2 billion dollars with credit default swaps are reported.The swaps of credit default agreements negatively can impact these five US banks very quickly. The graph and tables following are from the US Comptroller of the Currency, Administer of National Banks.      

The following table shows the amount of such swaps in millions of dollars ($42 trillion dollars at JPM).  Note the leverage of total assets to swaps and the high percentage of derivatives which are swaps.  The leverage is the ratio of total assets to derivatives.

What is a credit default “swap?”   When government entities or corporations issue bonds, they may buy credit default insurance for those bonds to pay in case of default.   This insurance allows a lower rate of interest and enables many investment funds to buy this “safe” debt as required by their rules.  This insurance cost is paid out of the initial proceeds of the bond offering and is made by some large entity, which could pay off, if necessary.  The five large US banks see this as a great cash generator with any liability to come in future years, after the present executives are retired.  In order to spread the risk to others, these banks trade shares of this liability for losses (credit defaults) with other banks, hence called a swap.

Credit defaults are liabilities not assets, which you trade for another liability.  Banks trade or can pay money to the acquirer of such credit default shares.  The receivers of such credit default swaps are other financial institutions or hedge funds.  Or, I’ll trade one Greek credit default share for for four of your Widget Corp bond credit default shares.

As already reported, some Greek debt has already defaulted and the insured parts of those losses will be spread around to all the holders of those Greek swaps.  JPMorgan, after making many unidentified swaps, was left with a $2 billion dollar assortment of lower value credit defaults claimed to be in corporate bond credit defaults.  Did JPMorgan try to dispose of its Greek, Spanish and Italian credit defaults and got stuck with worse junk?   JPMorgan’s losses are just the tip of the coming credit default losses on Greek and other EU nation’s debt which will be absorbed by the many players in credit default swaps.

Enter the government clowns and scoundrels, aka politicians and bureaucrats, looking to assigning blame:  Under Dodd-Frank law, a Volker rule is to be put in place in July to limit speculative bets using a bank’s capital.   The SEC is investigating JPMorgan losses.  But as reported here, Schumer and Eric Holder are the hyenas in charge of the financial chicken coop.   Did the smartest man in the room, aka Obama, learn about credit default swaps in his affirmative action “Finance Simplified” course?  Does Tim Geithner, who was unable to correctly answer the question whether he had earnings outside of the USA on his Federal Income Tax program, understand credit default swaps?  Will Jamie Dimon, CEO of JPMorgan, who is on the NY Federal Reserve Board resign as requested by Massachusetts Senate candidate, “Pocahontas” Warren?   Will the Federal Reserve bailout any of the five too-big-to-fail banks for losses from credit defaults exceeding capital?  Does Ron Paul understand credit default swaps or the supervision of banks? Where is Ron Paul on credit default swaps in his House Committees?  Were the moral hazards of profits from credit default fees received up-front with possible losses much later or bailed-out by the Federal Reserve too great? 

Just ahead:  “Greece’s deputy prime minister has said the country will run out of money in six weeks unless it honours its bitterly-disputed EU bailout deal.    Alexis Tsipras, former student Communist leader, whose party took second place in elections, “insists Brussels and Berlin will not force Greece out of the euro because of the contagion effect this would have on Portugal, Ireland and Spain.”   What happens when the holders of defaulted insured Greek and other EU defaulted bonds want payment on their insurance?    The issuing bank may claim they swapped the obligation to pay to other parties, like hedge funds or then insolvent banks.  Instead of receiving insurance payouts, the holders of insured debt could become parties to Federal legal actions involving the issuing US bank and all the other holders of those swapped credit defaults.    Three heads rolled at JPMorgan, including Ina Drew, 55, one of two women on the operating committee at JPMorgan.    Will other bank weasels be allowed to escape?  Were the credit defaults offered in swaps already known ready to default and thus frauds/crimes by the traders as may be claimed by final holders of the swaps?  Or were the swaps innocent errors due to incompetence, or greed?

The winners:  the lawyers get richer.  The losers: the defaulted bond holders, un-defaulted bond holders due to rising interest rates, banks, bank stocks and the taxpayers paying through the Federal Reserve or with another TARP bailout.   Did you believe that losses in Greek and other European defaults would stay in Europe?  Look at the graph above to see who holds most all of the derivatives.   Will derivatives become weapons of mass destruction for the five too-big-to-fail US banks?  See the latest opinion on Zero Hedge“the problems facing the EU (Spain and Italy) are too large to be bailed out. There simply aren’t any funds or entities large enough to handle these issues.”     Quo vadis, Romney?   

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