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(en) Britain, Anarchist Federation, Organise! magazine #75 - What are they talking About? WORDS: SEAN MURPHY

Date Mon, 01 Nov 2010 12:30:23 +0200


Financial ‘experts’ and economists seem to speak a different language to the rest of us. They rely on us not understanding what they’re on about. They know that if the gamble which constitutes the supposedly all-powerful ‘markets’ is revealed tus we will see just how crazy a system capitalism actually is. ---- But the truth is revolutionary and it is important that we look behind their jargon. Here we explain just a few of the most commonly heard terms. ---- CREDIT DEFAULT SWAP (CDS) ---- At its most basic a CDS is basically an insurance policy taken out against a loan default. ---- For Example: Bank A is owed $100 million by Bank B at an interest rate of 5%, giving A an income of $5million per year from B. Bank A goes to Bank C and buys ‘protection’ against the possibility of Bank B defaulting on the loan, for $500,000 per year.

This is a Credit Default Swap (CDS). Good business for
all it seems – A retains $4.5 million per year of the in-
terest and C has an income of $500,000 per annum for
doing basically nothing. As long as B is able to repay
the loan at the end of the 10-year term all are happy.
But what happens if B defaults? Now Bank C owes the
$100 million to A. But that’s the gamble it was willing
to take. And more than likely C has ‘hedged its bets’ by
selling on the risk to another ‘insurer’.

WHAT’S A ‘NAKED’ CREDIT DEFAULT SWAP?

This moves the CDS from ‘insurance’ to ‘gamble’.
Take the example above and now enter Bank D. Even
though it has had nothing to do with the initial transac-
tion between A and B, Bank D can also buy a CDS on
that transaction from B, a “Naked Credit Default Swap”.
Again it seems like good business for Bank C – another
$500,000 per year for doing nothing. Bank D is taking
a punt on the hope of B defaulting.

CDSs are usually taken out for between 1 and 10
years, with the average being 5 years. In this ex-
ample, D is taking the gamble of paying $500,000 per
year for 5 years to C in the hope that B will default on
his loan to A in which event C will owe the amount of
B’s debt ($100million) to D.

Now imagine the scenario whereby Bank C has sold
100 CDSs to different financial speculators on this
transaction. As long as everything is going well and
Bank B pays back the original loan to A as agreed,
Bank C appears to have a booming business – an
income of $50 million per year for doing little or nothing.

But what happens if B defaults on the loan? Now C
finds itself owing $100 million to A from the origi-
nal CDS, and $100 million to each of the 100 holders
of the ‘naked CDSs’ – a bill of a whopping $10,000
million. Suddenly the $50 million per annum income
doesn’t seem quite so much.

CDSs have existed since the early 1990s but it was the
passing of the Commodity Futures Modernisation Act
(CFMA) by the Clinton government in 2000 that lega-
lised the concept of being able to take out “insurance”
on a transaction that you were not party to. By the end
of 2007 there were $62.2 trillion worth of CDSs in the
market, and well over half of these were pure specula-
tion by ‘financiers’ who did not hold the original debt.

This was casino capitalism at its most blatant. And it
was totally unregulated.

COLLATERALISED DEBT OBLIGATION (CDO)

CDOs basically allow credit risk to be sold or passed on
from one financial institution to another. The essential
principle is that a package of asset-backed securities
(e.g. home loans/mortgages, commercial real estate
loans etc.) is bundled together and sold on in several
tranches. The originator of the mortgages or loans is
spreading their risk and the purchasers of the various
tranches are making an investment in the expected
return. In the middle is usually an investment bank
which puts the package together, sells it on for a com-
mission and earns a fee for ‘managing’ the ‘invest-
ment’.

Of course the whole thing is predicated on the assets
backing the loans holding their value and the mortag-
ees or borrowers repaying the original loans.

But - Take any one of the many sub-prime mortgage
lenders which sprung up in the U.S. during the 1990s.
Their basic modus operandi was to sell mortgages as
fast as they could with little thought for whether
the mortgagees were in a position to repay the
loans. This was most often achieved through
use of Adjustable Rate Mortgages (ARMs). In
order to sign people up these ARMs were of-
fered at an initial rate of just 1 or 2 %. But this
rate would then be adjusted upwards within 1 to
3 years, jumping to as high as maybe 8 or 9%.

Because they were going to sell the debt on
almost immediately, the mortgage company
didn’t care whether the loans were ever going
to be paid back. As quick as they could sell
them, they packaged together a bundle (say a
thousand) of these mortgages and sold the bun-
dle on to one of the bigger Wall Street banks.

The bank would then bundle up the bundles,
splice them up and sell them on as investments.
But the banks, pension funds or hedge funds
buying these investments were doing so on the
basis that the original borrower was going to
repay the loan plus interest thereby giving an
8 – 9% return. But when the property bubble
burst and when holders of sub-prime mortgages
began to default on their loans, a lot of holders
of CDOs found their investments were actually
worthless.

And when a mortgage went unpaid in California,
it could be a hedge fund based in Hong Kong
that held the worthless deeds to the property.

CDOs were another invention of the 1990s
regulation-free markets. The first one was is-
sued in 1987. By the end of 2006 more than €2
trillion was tied up in CDOs.

COLLATERALISED LOAN OBLIGATION (CLO)

A CLO is a type of CDO. Instead of being main-
ly based on home loans, CLOs are mainly based
on business loans – often loans associated with
company takeovers or leveraged buyouts. Lev-
eraged Buyout (LBO) companies – also known
as private equity firms are one of the predators
of the business world.

The LBO company borrows a large sum of mon-
ey (probably several billion dollars) from a Wall
Street bank in order to buy out a business e.g.
a retail chain or a hotel chain. The collateral of-
fered is the business being bought. The plan is
usually to ‘rationalise’ the business (which usu-
ally involves sacking loads of workers, cutting
wages and working conditions etc.) and sell it
on at a profit and thus repay the original loan.

Just as described above the Wall Street bank
bundles up groups of such loans, splices them
and sells them on as investments. It was a
‘market’ that exploded as the financial boom
was about to go bust. In his book on the col-
lapse of Lehman Brothers Bank “A Colossal
Failure of Common Sense”, former Lehman vice
president Larry McDonald recounts how “In a
land as innately avaricious as Wall Street, the
kind of cold-blooded corporate raiding involved
in LBOs is simply too big a temptation for the
kind of grotesque personal greed that has slith-
ered through Wall Street for more than a centu-
ry…..in summer 2005….LBOs had exploded on a
scale beyond anyone’s imagination…..Across the
industry, stock sales and mergers and takeovers
amounted to $117 billion…..The value of take-
overs over three months in mid-2005 was up
41 percent on the previous year. The leveraged-
buyout specialists estimated $50 billion worth
of takeovers in the same three months, with a
year-end figure likely to be around $180 billion.”
(p. 141)

But when the house of cards came tumbling
down, it left devastation in its wake.

COMMERCIAL PAPER MARKET

Commercial Paper is a short-term loan (less
than 9 months) used by banks and large cor-
porations to meet their short-term debt obliga-
tions. It is a way in which large banks with ‘blue
chip’ credit rating lend to each other. Because it
is unregulated the Commercial Paper Market is
the quickest and easiest way for them to raise
fast loans.

Commercial Paper is essentially a promissory
note, and as such has been around since the
19th Century. But in the 1990s and early years
of the noughties Commercial Paper began to
be used by the big banks as a means by which
they would borrow short-term money and invest
it in longer-term mortgage-backed securities
which paid a higher yield. When it came to time
to re-pay the short-term paper loan, they would
simply take another one from a different bank
and use this to keep the ‘investment’ going.
The amount of money outstanding in the U.S.
Commercial Paper market mushroomed in the
period 2001-2007 from $1.25 trillion to over
$2.25 trillion. With much of this dependent on
the U.S. housing market we all know now what
was around the corner!

SHORT SELLING

Short Selling refers to the practice of selling as-
sets (shares or bonds) that have been borrowed
from a broker with the intention of buying back
identical assets at a later date in order to pay
them back to the broker. The seller is taking
a gamble that the share price will fall so that
he will make a profit on the transaction. The
actual owner of the shares need not even be
aware that her shares have been lent, sold and
returned.
_________________________________________
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