Dr Dread: All clear in credit derivatives?

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Forget platitudes from bank bosses and signs of life in the credit derivatives market, it's all downhill from here, says our resident pessimist.

After a deluge of favourable information in the past two weeks, an optimist might be inclined to think the worst of the credit crisis is over.

The CEO of Lehman says the "worst is behind us", and the CEO of Goldman Sachs declares, "We're closer to the end than the beginning." Morgan Stanley's CEO intones the credit-market contraction will probably last no more than "a couple of quarters" longer.

Superficially, things are even looking up in some areas of credit derivatives. This week, the International Swaps and Derivatives Association announced that the total volume of outstanding credit derivatives contracts stood at $62 trillion at the end of last year, up from $34 trillion a year earlier.

At the same time, banks have apparently devised a new tool to deal with counterparty risk - contingent credit default swaps (CCDS), another acronym thrown into the alphabet soup of derivatives - just what we need right now.

CDS are not what they seem

But before we lose sight of the big picture, let us take stock and think rationally.

Growth in CDS may be another case of smokescreens and mirrors.

In this week's edition of Barrons, Martin Mayer kindly points out that CDS products are, by their nature, prone to rampant growth.

When the holder of one CDS sells it on, the new owner becomes the beneficiary of the insurance contract it entails. But the insurer might then find someone who will accept a lower premium to carry the burden of the insurance, allowing him to sell on the risk.

"The one trade thus generates two new instruments, with four new counterparties, and as the daisy chain of reinsurance expands, the numbers become ridiculous," says Mayer.

Don't forget that derivatives accounted for a large percentage of all investment banks' earnings. This has been banks' gravy train, making it natural that to solve the problem of derivatives, more derivatives are created to address the shortcomings. Think.

Investment banks are constantly at the Fed begging bowl facility or raising capital via sales of stock. We are told that they don't really need the funds, but have undertaken this activity to prove there is no stigma in doing so. Think.

Total volume of outstanding derivatives at the end of last year was 10 times the level of four years ago - a damning statement of the precarious state of the financial system leverage. Think.

Total losses from this crisis would be around $50bn, we were told by the banks - ever so slowly that number has crept up and is now closer to $250bn. Respected economists and the IMF have estimated it at closer to $1 trillion. This does not even account for the non-financial companies that are infected with the radioactive toxic stuff. Think.

Moving east

To quote Ross Perot, "that great sucking sound" you hear is jobs moving East. This is not going to stop as the centre of economic gravity moves relentlessly East, as the effects of the financial crisis begin to infect the real economy of the West.

What we are witnessing before our very eyes is what some have called a "slow motion train wreck", a "CAT-5 hurricane". The problem most people have in fathoming the present situation is that this kind of a perfect storm has not been seen by the past two to three generations.

We have a credit and solvency crisis, a systemic banking (and shadow banking) seizure. While liquidity injections can smooth the fallout, they cannot stop the inevitable.

The consequences of these trillions of dollars of worthless derivatives that have no market value and yet are being marked at some arbitary level (with the blessing of the authorities) must manifest and will manifest. It is called cause and effect. The absence of an effect given a cause is called a miracle.

That is what you are praying for if you naively believe the "worst is behind us".

The worst has not even begun.

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