The River

Thursday, September 18, 2008

100 Year Crash: McCain advisor spurred $62 trillion derivatives market that will swamp global markets

Posted Sep 15th 2008 9:09AM by Peter Cohan

Lurking in the background of this weekend's collapse of two of Wall Street's biggest names, is a $62 trillion segment of the $450 trillion market for derivatives that grew huge thanks to John McCain's chief economic advisor, Phil "Americans are Whiners" Gramm. That's because in December 2000, Gramm, while a U.S. Senator, snuck in a 262-page amendment to a government re-authorization bill that created what is now the $62 trillion market for credit default swaps (CDSs).

I realize it is painful to read about yet another Wall Street acronym, but this is important because it will help you understand why the global financial markets are collapsing. And it will give you information to consider when you vote in November. CDSs are like insurance policies for bondholders. In exchange for a premium, the bondholders get insurance in case the bondholder can't pay. As I posted, in the case of the $1.4 trillion worth of Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FRE) bonds, the government's nationalization last Sunday triggered the CDSs on those bonds. The people who received the CDS premiums are now obligated to deliver those bonds to the ones who paid the premiums.

Gramm's 262-page amendment, dubbed "The Commodity Futures Modernization Act," according to Texas Observer, freed financial institutions from oversight of their CDS transactions. "Prior to its passage, they say, banks underwrote mortgages and were responsible for the risks involved. Now, through the use of [CDSs]-which in theory insure the banks against bad debts-those risks are passed along to insurance companies and other investors," wrote Texas Observer.

How does this relate to Lehman's bankruptcy? "[CDSs] were a key factor in encouraging lenders to feel they could make loans without knowing the risks or whether the loan would be paid back. The Commodity Futures Modernization Act freed them of federal oversight," according to Texas Monthly. And it was due to these CDSs that Wall Street held an emergency session yesterday to try to minimize the damage of Lehman's CDSs and other derivatives. Unfortunately, this session did not produce much thanks to the built-in lack of knowledge of the risks in these transactions that Gramm's legislation ensured.

You are going to be reading more and more about CDSs over the months ahead -- it will become as familiar as the phrase subprime mortgage was in 2007. Unfortunately, there were "only" $1.3 trillion worth of subprime mortgages and the CDS market is 48 times bigger than that -- and more than four times bigger than U.S. GDP. And since nobody has ever had to deal with this volume of CDS unwindings, it is impossible to calculate how much they will cost.

One thing is clear. If you think America is a nation of whiners and this is a mental recession, I strongly urge you to vote for McCain. But if you take a look at how much you are paying at the gas pump, how much of your retirement will be wiped out in the months ahead, and how you will pay all those bills as the unemployment rate climbs higher, it might be worth considering whether you can afford to elect a man who relies on Phil Gramm for economic advice.

Peter Cohan is President of Peter S. Cohan & Associates. He also teaches management at Babson College and edits The Cohan Letter. He has no financial interest in the securities mentioned.

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