2008-09-29 to 2008-10-05

Credit Default Swamps
To get an idea of just how much bigger the problem is than any possible solution the federal government can come up with, let’s look back at a financial instrument that we first introduced to Elliott Wave Financial Forecast readers in May 2005, the credit default swap (CDS). When Elliott Wave Financial Forecast first discussed these instruments in connection with the economy’s unavoidable advance toward the purge phase of the interest rate cycle, we also noted the appearance of “some whole new risk exposures such as credit default swaps, which by some estimates now total more than $8 trillion, or 2/3 of GDP.” At that point, the CDS boom had only just begun. The bar chart above shows the exponential growth that has since taken place. At $62 trillion, credit default swaps’ value hit 4.3 times annual U.S. GDP at its peak last December.

The extraordinary part that these instruments played at the very end of the Great Asset Mania’s peaking process revolves around credit’s pivotal role in the boom-bust cycle. Every boom runs higher when the willingness to lend disconnects from the value of the underlying collateral. Borrowed money ratchets up demand, pushing up prices and increasing the supply of credit. The bust comes when optimism finally wanes and the cycle reverses. Tighter credit reduces demand, driving down prices and the attendant collateral values. But the CDS introduced an intermediate step by allegedly allowing bond holders to insure against default, which they did in droves. We say allegedly because, as Conquer the Crash points out, default itself will nullify many insurance and derivatives contracts, even those that were supposed to pay off in the event of non-payment. In the summer of 2006, Elliott Wave Financial Forecast noted that CDS’s were being “widely used as insurance against default in lieu of selling distressed bonds outright.” In other words, the CDS’s delayed the selling that otherwise would have come naturally, a fitting component of the b-wave rally. The CDS market was obviously becoming a casino unto itself because total issuance eventually grew to be 6 times the total value of U.S. corporate debt. Its size and wild swings in value caused Elliott Wave Financial Forecast to issue several warnings......

...... All it took was one major credit event to bring down the CDS house. The failure of Fannie and Freddie tipped the first domino, AIG. In the chain reaction that followed, Wall Street firms used the instruments to drive each other out of business or into drastically different financial entities. According to Bloomberg, “The swaps became a one way bet on the demise of the financial institutions as traders hedged the risk that their partners might implode.” The SEC now promises to “crack down” on the unregulated CDS market, but any such move should prove superfluous, as credit default swaps will go away just as portfolio insurance disappeared after the 1987 crash. The first tick down after 7 straight years of growth has already occurred. CDS’s will, however, be long remembered as a monument to the level of complacency at a Grand Supercycle-degree peak.