Please bear with me here, as the thing will become clear:
- An investment trust owns a £1 million corporation bond, issued by a private housing firm.
- If there is a risk the private housing firm may default on repayments, the investment trust may buy a Credit Default Swap from a hedge fund. The CDS is worth £1 million.
- The investment trust will pay an interest on this credit default swap of say 3%. This could involve payments of £30,000 a year for the duration of the contract.
- If the private housing firm doesn’t default, the hedge fund gains the interest from the investment bank and pays nothing out. It is simple profit.
- If the private housing firm does default, then the hedge fund has to pay compensation to the investment bank of £1 million – the value of the credit default swap.
- Therefore the hedge fund takes on a larger risk and could end up paying £1million.
- The higher the perceived risk of the bond, the higher the interest rate the hedge fund will require.
Seems like a perfectly straightforward transaction, except for a number of things:
As the FT article says:
- For over 250 years, insurance markets have required buyers to have an insurable interest. Your neighbours cannot buy insurance on your house because they have no insurable interest in it. Such insurance is considered unhealthy because it would cause the neighbour to want your house to burn down – and maybe even light the match.
- If there are good profits in this trade though, both the regulators [themselves corrupt] and down through them, you, are going to do this. Perhaps you’re not actively encouraged but you know there’s little risk in doing it because though the regulators can hit you if and when they want, you bank on the fact that it’s not in their interests to hit you.
On the surface, it looks, as just mentioned, perfectly straightforward and everyone’s happy. Except for certain things:
- The house-burning-down incentive and the disconnect between what is being insured in the first place and the game going on elsewhere, creates a subtle and yet ultimately vital disconnect between you and the real world you’re dealing with. As you become more successful at it, so the disconnect with ordinary people widens. It’s Anton le Vey’s “do as you will” and to hell with everyone else.
- The fact is that in any debt game, there is a loser and the loser is caught inside a bubble, not unlike, as the FT says, a piñata. Wiki describes this as:
Toward the end of the party, usually after the cutting of the cake, an announcement is made that the piñata will be ‘broken’ and each child is given an empty party bag. All the children gather directly underneath the piñata and each child is given a string to hold.
Then, at the count of three, the children pull their strings all at the same time. This opens the hidden trap-door (or ‘breaks’ the piñata) and the children receive a shower of candy and confetti while they rush to fill up their bags with the treats.
In the current Greek piñata, Greece’s travails are often measured by reference to the market in credit default swaps (CDS), a kind of insurance against default by Greece.
- As with any insurance, greater risks entail higher prices to buy the protection. But what happens if the price of insurance is no longer anchored to the underlying risk, similar, I opined to the estimable Mark Wadsworth yesterday, when there is nothing left in our coffers in the UK to back the electronic deals going on?
- When we look behind CDS prices, we don’t see an objective measure of the public finances of Greece, but something very different. Sellers are typically pension funds looking to earn an “insurance” premium and buyers are often hedge funds looking to make a quick turn. In the middle you have Goldman Sachs or another large bank booking a fat spread.
Now comes the piñata party for the kiddies:
- Banks grab their sticks and start pounding thinly traded Greek bonds and pushing out the spread between Greek and the benchmark German CDS price.
- Step two is a call on the pension funds to put up more margin, or security, as the price has moved in favour of the buyer.
- The margin money is shovelled to the hedge funds, which enjoy the cash and paper profits and the 20 per cent performance fees that follow. How convenient when this happens in December in time for the annual accounts, as was recently the case. [This dynamic of pushing out spreads and calling in margin is the same one that played out at Long-Term Capital Management in 1998 and AIG in 2008 and it is happening again, this time in Europe.]
- Eventually the money flow will be reversed, when a bail-out is announced, but in the meantime pension funds earn premium, banks earn spreads, hedge funds earn fees and everyone’s a winner – except the hapless hedge fund investors, who suffer the fees on fleeting performance, and the unfortunate inhabitants of the piñata.
This is a game where the loser is the one inside the piñata in the first place but unlike sweets inside a papier-mâché bag, what’s inside is you, trying to earn a bit on the side, to hedge against the disconnect between salaries and soaring house prices and the negative equity as your currency unit purchases less and less and you are forced to go to credit.
Let’s look at you
- Your motives are pure – to protect your family and to have a bit of la dolce vita which you see everyone else having.
- Quick check – have any of you ever bought fuel or shopping with a credit card or do you pay cash? If the former, are you aware that each time you do it, you are buying without money, without anything concrete and helping out the very bankers you vilify for the rest of the day?
Let’s look at the traders
They’ve been virtually invited to participate in a game where the first rules which have been broken are that:
- Decent people don’t insure something in which they have no insurable interest. It creates a disconnect in the mind where people’s misery – i.e. there is always a loser, usually someone ill-equipped to cope with such loss – is the commodity in question. Not the bricks and mortar but the misery.
- Decent people don’t insure the uninsurable, high risk defaulter, i.e. you in a recession, when you see fat profits being made by Them but you’re getting none of it, just a steady stream of utilities and other bills through the letterbox. You are high risk and people are watching you, betting on whether you’ll default or not. If you have a government in place with an interest in spending all the country’s reserves and getting everyone on to the human cog controllable dole, the State teat for the little piglets, us, then all the better.
So already, the noble idea of trade and barter, where someone buys your commodity and you buy a third person’s and so it goes on – that idea has moved on. In plain English, the idea has been perverted.
By whom ? Don’t ask. If I say the Venetian Lombard usurers of the C14th, you’d not wish to go down that path, so let’s stop that right there.
The Greeks are hopeless, they’re well known as hopeless and one has only to look at Greek ferry timetables and safety standards to see this. Perfect fodder for exploitation – they supply the keen aspiration for something better, the bankers supply the cash.
In the end, it all goes pear-shaped, the bankers are bailed out by the people who run the economy, i.e. the bankers, to whom the government itself is in thrall, the ordinary person has a few new taxes dropped on him/her and everyone’s happy … except for the “victims” who, as the bankers point out, went into it themselves. No one held a gun to their heads.
The socialists are, of course, delighted because the people have now been softened up enough to accept State control [throw in an MPs’ expenses scandal with three of them saying they’re above the law, which everyone’s too demoralized to even care about any more], the power returns to the hands of “the people”, so they say [but you try getting an MP to pledge to a referendum, i.e. the people’s voice, vox populi and see how far you get], – so it’s not the people in control at all, after the Big Change.
It’s actually more oligarchs, this time State ones and we all know how well the State administers things and safeguards our money. No hare-brained schemes for them, no “smoking police”, no selling our gold reserves at rock bottom prices. Good, solid administrators without a trace of PC to them and no PFI greed either. That’s the wise State in charge of our infantilization.
And where are the bankers?
Why, in government of course or else out on their estates or in the Bahamas, where one gets third world service at first world prices.