Seven Days That Shook Wall Street

A look back at the historic-and often scary-events that changed the U.S. financial system forever BUSINESS WEEK [McGraw-Hill] - By Phil Mintz - September 19, 2008 It was the week that shook the financial world to the core. On Friday, Sept. 12, traders left the New York Stock Exchange for the weekend. But key banking officials, facing the impending failure of the venerable Lehman Brothers investment house and a shaky outlook for two other huge financial players-investment firm Merrill Lynch (MER) and insurance giant American International Group (AIG)-began a series of weekend meetings in an effort to prevent a possible collapse of the global financial system. Over the next seven days, the nation's financial leaders, captained by Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke, produced a rapid succession of moves that reversed a decades-long trend toward financial deregulation and fundamentally changed the face of the American financial system. Lehman failed and Merrill was sold to Bank of America (BAC). The government took effective control of AIG in an $85 billion bailout. And, in the biggest intervention of all, officials proposed to purchase the troubled mortgage assets of financial firms, a move that could cost hundreds of billions of additional dollars. Meanwhile, worried investors sent the stock markets into a dizzying ride of huge gains and losses. Here's how the events unfolded: Friday, Sept. 12: The trading week ends with the fate of 158-year-old Lehman Brothers in grave doubt. Its stock had fallen sharply due to fears over its financial condition. Paulson, Bernanke, and New York Fed President Tim Geithner begin a series of meetings in Lower Manhattan with top bankers in an effort to engineer a bailout of Lehman, which had bet heavily in the subprime mortgage market. Two possible buyers emerge: Britain's Barclays (BCS) and Bank of America. Saturday, Sept. 13: Talks on a possible Lehman buyout continue. The would-be rescuers look to the government to take on some of the risk, as it did in the shotgun sale of Bear Stearns to JPMorgan Chase (JPM) in March and the effective nationalization on Sept. 8 of mortgage giants Fannie Mae (FNM) and Freddie Mac (FRE). Government officials hold fast that there will be no federal bailout. Talks are inconclusive. Sunday, Sept. 14: The negotiators continue meeting, facing a deadline to act before Asian markets open for Monday morning trading. But government officials insist there will be no federal backing of a Lehman rescue. With no help from Washington forthcoming, Barclays-the only possibility left after Bank of America leaves the table-withdraws. Lehman is done for. Meanwhile, Merrill Lynch CEO John Thain, seeing the writing on the wall, arranges the sale of his company to Bank of America for about $50 billion. In one day, the fates of two storied companies are sealed. Monday, Sept. 15: Lehman Brothers Holdings, the bank's holding company, files for Chapter 11 bankruptcy protection and says it will try to sell key business units. Investor concern now turns to the fate of AIG, fearing a liquidity crisis. Rating agencies cut AIG's credit rating. Despite reassurances about the economy from Paulson and President George W. Bush, the stock market plummets. The Dow Jones industrial average drops more than 504 points, or 4.4%, the biggest loss since right after the September 11, 2001, terror attacks. The failure also roils overseas stocks, sending them plunging. Meanwhile, concerns about a slowing economy take oil below the psychological benchmark of $100 a barrel, its lowest level since February. Tuesday, Sept. 16: The Federal Reserve meets and keeps the federal funds rate unchanged at 2%. Asian markets, some of which had been closed for a holiday on Monday, plummet. The Russian stock market goes into a tailspin, with the largest exchange down more than 17% before the Russian government halts trading. Managers of the Primary Fund, a supposedly supersafe money market fund, say that shares have fallen below the sacrosanct $1 valuation. Meanwhile, Goldman Sachs (GS) and Morgan Stanley (MS), the two remaining independent investment banks, report stronger-than-expected results. However, investors continue to beat down the companies' shares. Amid all the turbulence, U.S. officials decide that AIG is indeed "too big to fail." In a move that would have been unthinkable before the credit crisis began, the Fed arranges to lend $85 billion to AIG in exchange for a 79.9% equity stake. The deal is announced Tuesday evening. Even before the deal is finalized, the Dow reverses an earlier loss and gains 141 points. Wednesday, Sept. 17: The government bailout of AIG fails to stem investor fears as they flee to safety. Credit markets tighten. The New York Times reports that Washington Mutual (WM), the nation's largest thrift, has put itself up for sale. The Dow plunges 449 points. Thursday, Sept. 18: The New York Times reports that Morgan Stanley has "stepped up" merger talks with Wachovia (WB). The Fed moves to pump money into the financial system through lending programs operated by several overseas central banks and the Fed's own moves. At the same time, the government begins action on the hugest bailout of all, committing hundreds of billions of taxpayer dollars to buy troubled mortgage assets from beleaguered financial institutions. As word of the evolving plan spreads, stocks rally. The Dow closes up 410 points. In the evening, Paulson and Bernanke and Securities & Exchange Commission Chairman Christopher Cox go to the U.S. Capitol to brief lawmakers on the plan, which requires congressional authorization. Friday, Sept. 19: The buyout plan-with few firm details-is announced and stocks soar worldwide. President Bush says the move puts "a significant amount of taxpayer dollars on the line," but he says the risk of not acting "would be far higher." In additional actions, the Treasury and Fed act to guarantee the assets of money-market funds, which had been threatened by the meltdown of the financial markets, and the SEC places a temporary ban on the short-selling of nearly 799 financial stocks. The Dow closes up 368.75 points, 45 points below where it was a week earlier but still 911 points over its bottom on Thursday morning. A momentous week indeed, but there is no sign the economic drama will limit itself to a mere seven days. Lawmakers and regulators are to work through this weekend in an effort to devise bailout plan legislation that can come to a vote next week. The bipartisan consensus surrounding the deal can come undone as the details are ironed out. But for drama, it will be hard to match events that have reshaped the U.S. financial landscape for years, if not decades to come. Mintz is BusinessWeek.com's B-schools channel editor in New York. Original Report http://www.businessweek.com/print/bwdaily/dnflash/content/sep2008/db20080919_945045.htm FAIR USE NOTICE: This blog contains copyrighted material the use of which has not always been specifically authorized by the copyright owner. We are making such material available in our efforts to advance understanding of religious, environmental, political, human rights, economic, democracy, scientific, and social justice issues, etc. We believe this constitutes a 'fair use' of any such copyrighted material as provided for in section 107 of the US Copyright Law. In accordance with Title 17 U.S.C. Section 107, the material on this site is distributed without profit to those who have expressed a prior interest in receiving the included information for research and educational purposes. 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Digging out the truth?

THE JERUSALEM POST [Mirkaei Tikshoret/CanWest] - Op-Ed By Lela Gilbert - August 14, 2008 My first introduction to Jerusalem in 2006 took place on Tisha Be'av, the fast commemorating the destruction of the First and Second Temples. I stood at the Western Wall, during that time of the Second War in Lebanon, watching thousands of Jewish faithful, from all different walks of life - women and men, soldiers and Hassidim, Sephardim and Ashkenazim - gathered in unity to remember and to mourn. It was like entering the very soul of Israel. This Tisha Be'av caused me to reflect further on those lost Temples, particularly now that I have spent two years in the country, during which I had occasion to visit the Temple Mount. After passing through two security checks before entering, a different world appeared - one with no visible vestige of Judaism - on that ancient and holiest of Jewish sites. Christianity hasn't fared any better. In fact, for Christians, the writing is on the wall - literally and figuratively - the wall inside the Dome of the Rock. In Arabic calligraphy dating from the seventh century, the text declares that God has no son; that Jesus was not resurrected (Islam also denies that he was crucified); that Jews and Christians, "the People of the Book," transgress by not embracing Muhammad's revelation; and that Allah's reckoning will come swiftly on those who do not believe. Christians' attachment to the Temple Mount is based on Jesus's words and deeds as recorded in the Gospels. It was strange enough for me to discover, therefore, that Jews and Christians are not permitted to read their scriptures or pray aloud there. But it wasn't until learning that during the 2000 Camp David negotiations, PLO chairman Yasser Arafat had denied that any Jewish Temple had ever existed on the Mount that I grasped the depth of the divergence from the Hebrew Scripture, New Testament and historical records that is out there, and not as fringe an idea as one might assume. SIFTING THROUGH tons of rubble that had been illicitly dug up on the Temple Mount by the Muslim Wakf and stealthily dumped into a landfill, biblical archeologist Dr. Gabriel Barkay, professor at Bar-Ilan University, is in the midst of the project of a lifetime. I put the question of Temple denial to him. "This denial of the historical, spiritual and archeological connections of the Jews to the Temple Mount is something new," he says. "There was always talk about the temple of Solomon in Jerusalem - called the 'praise of Jerusalem'- in Arabic literature, in Islamic literature. This new idea of Temple denial is due to the Arabic fear of Jewish aspirations connected to the Temple Mount. It is part of something I call the 'cultural intifada.'" Barkay says the change took place in the 1990s: "In the Washington DC think tanks surrounding president Bill Clinton, it was understood that the Temple Mount was the crux of the problem of the Middle East conflict. These think tanks decided that if there could be 'split sovereignty' on the Temple Mount, then split sovereignty could also be achieved over the entire land of Palestine. So they suggested that in a future agreement, the Temple Mount would be split horizontally. That is to say that whatever is above ground, the part that includes the shrines of the Muslims, would be under Palestinian sovereignty. Whatever is underground, which would include the remnants of the Temple of the Jews, would be under Israeli sovereignty. "It's a brilliant idea, an excellent idea, but totally idiotic from a practical point of view. You cannot have a building standing with its foundations in another country. You cannot have a building with the infrastructure and the plumbing in another country. And you cannot have sovereignty on the subground without having accessibility to the subground, because the accessibility is from above ground. The whole thing was stupid." Barkay explains that the Temple Mount is honeycombed with more than 50 different cavities, holes, passageways and cisterns that are "filled with earth which is saturated with very valuable archeological materials. Enormous damage was done in these works which were carried out mainly from 1996 and onward. The idea that came from the circles surrounding Bill Clinton and leaked to the Wakf authorities is what generated the illicit building activities - I wouldn't call them excavations - but destructive work which was carried out brutally on the Temple Mount. The fear, the fear of anything representing a Jewish presence on the Temple Mount drove them mad." PRIOR TO my own visits to the Mount, I had been warned not to carry a bible or "holy objects" with me, and to stay away from the Dome of the Rock shrine and the Aksa Mosque, into which non-Muslims are forbidden to go. Nor was I allowed to see a third edifice which I'd read about - the Marwani Mosque - a gigantic, subterranean building, located in the southeast corner of the Temple Mount Plaza. In 1996, the Wakf had reconfigured an underground structure, formerly known as "Solomon's Stables," into a mosque. Their contractors lowered the inside surface of the building by removing large quantities of priceless soil, rich in archeological evidence. According to Barkay, the history they hauled away in dump trucks was not Muslim. "The building was never a mosque. It is actually more connected to traditions about Jesus. There are quite solid hints in the literature of the existence of an early Christian church there, marking the place where St. James was killed in the first century. The place is more Christian than Muslim." In November 1999, the Wakf asked permission from the Israeli government to open an emergency exit leading from the Marwani Mosque. "The prime minister at that time was Ehud Barak, and as usual he didn't consult with anybody else," Barkay recalls. "He gave them permission. But instead of an emergency exit, they created a main entrance to the building - a monumental entrance. For that entrance, they dug a pit 40 meters long and 12 meters deep. They did it with bulldozers in the most destructive manner possible, that of a bull in a china shop. The work on that place should have been done carefully, not with bulldozers. They removed 400 truckloads of earth." For Barkay, sifting through those truckloads of material is essential, because it amounts to exploring a black hole in archeological history. Although Israel is one of the most excavated places in the world, explored continuously since the 1850s, the Temple Mount has been surveyed but never excavated. Therefore, ironically, the digging and removal of earth in the 1990s has provided a new opportunity. "At least it enables us to look at the soil, though everything comes from a very disturbed context," Barkay says. "But we know it comes from the Temple Mount. And we have tens of thousands of finds." These finds, that cover approximately 15,000 years, have altered the historic understanding of the area's history. Sponsored by the Ir David Foundation, volunteers working with Barkay have been sifting through the debris, and have found Stone Age flint implements. They have discovered pre-Israelite material, Bronze Age pottery, two Egyptian scarabs and several seals and seal impressions. One very significant find, confirming the recorded history of the Temple's existence, is the fragment of a bulla, a clay lump with a seal impression upon it, which is about 2,600 years old and dates from the First Temple period. Its inscription bears part of official's name, Gealyahu son of Immer. The Immer family is recorded in the Bible. "In Jeremiah 20:1," Barkay says, "probably the brother of Gealyahu is mentioned, a priestly man named Pashur son of Immer. He is introduced as the man in charge of the Temple." Findings from the time of Solomon's Temple up to the 20th century illuminate the raging conflicts of passing civilizations. "We have enormous quantities of war artifacts: We have lead slingshots of the Seleucid armies in the battles of Judah Maccabee. We have arrowheads of the army of Nebuchadnezzar, who destroyed the First Temple. We have arrowheads of the Hellenistic period. We have one arrowhead bearing distinguishing markings of having been shot by a catapult. Those machines were only used by the armies of Titus in 70 CE in the destruction of the Second Temple. We have stone slingshots; we have spearheads; and we have medieval arrowheads from the Crusader conquest of the Temple Mount. There are even bullets from both the Turkish army and the British army in World War I." Other findings on the Temple Mount - jewelry, coins, pottery shards and architectural fragments - provide specific details of human life spanning several millennia. "We have material dating back to the 10th century BCE, the time of David and Solomon. We have material from the time of the kings of Judah. We have material in abundance from the early Christian period. This is very significant, because it is written in most history books that the churches moved to the Church of the Holy Sepulcher after it was built (it dates back to at least the fourth century), and that thereafter the Temple Mount was neglected and was a garbage heap. But now we have to build a new history, based on archeological evidence. "We have fragments of capitals from church buildings. We have remnants of chancel screens that separated the presbytery from the nave of the church. We have several bronze weights for weighing gold coins from the Christian era. We have to rethink the role of the Temple Mount in the time of early Christianity. Was it a garbage heap? Or is that biased history? I think that history was ideological." Barkay says that large quantities of animal bones have been found on the Mount. "Bones are very important. We have pig bones which had to have come from pagan or Christian times. We also have bones of foxes. And that is interesting, because in the Talmud we have a story about foxes which until recently I thought was a legend." IN SPITE of these discoveries, Temple denial remains a growing phenomenon in Europe and America, particularly in leftist intellectual circles. It is supported by the reality that there are no visible remains of the temples of Jerusalem on the Temple Mount. Barkay contends that there were remains still visible in the 1960s and 1970s, which have either been removed or covered up by gardens. "The Islamic Wakf says, 'We are not going to let you dig, but show us any remains of the Temple.' You cannot have it both ways. If you don't allow people to dig, then don't use this absence of remains as an argument. "Temple denial is a very tragic harnessing of politics to change history. It is not a different interpretation of historical events or archeological evidence. This is something major. I think that Temple denial is more serious and more dangerous than Holocaust denial. Why? Because for the Holocaust there are still living witnesses. There are photographs; there are archives; there are the soldiers who released the prisoners; there are testimonies from the Nazis themselves. There were trials, a whole series of them, starting with Nuremberg. There are people who survived the Holocaust still among us. Concerning the Temple, there are no people among us who remember. "Still, [to deny the Temples], you have to dismiss the evidence of Flavius Josephus; you have to dismiss the evidence of the Mishna and of the Talmud; and you have to dismiss the writings of Roman and Greek historians who mention the Temple of Jerusalem. And you have to dismiss The Bible. That is, I think, way too much." The writer has authored or co-authored more than 60 books, primarily in the field of ecumenical Christian non-fiction. Her work includes the recently released biography Baroness Cox: Eyewitness to a Broken World and the award-winning Their Blood Cries Out, co-authored with Paul Marshall. She is also an Adjunct Fellow at the Center for Religious Freedom at the Hudson Institute. Original Report Here http://www.jpost.com/servlet/Satellite?cid=1218710365298&pagename=JPost%2FJPArticle%2FShowFull FAIR USE NOTICE: This blog contains copyrighted material the use of which has not always been specifically authorized by the copyright owner. We are making such material available in our efforts to advance understanding of religious, environmental, political, human rights, economic, democracy, scientific, and social justice issues, etc. We believe this constitutes a 'fair use' of any such copyrighted material as provided for in section 107 of the US Copyright Law. In accordance with Title 17 U.S.C. Section 107, the material on this site is distributed without profit to those who have expressed a prior interest in receiving the included information for research and educational purposes. For more information go to: http://www.law.cornell.edu/uscode/17/107.shtml. If you wish to use copyrighted material from this site for purposes of your own that go beyond 'fair use', you must obtain permission from the copyright owner.

The $55 trillion question

The financial crisis has put a spotlight on the obscure world of credit default swaps - which trade in a vast, unregulated market that most people haven't heard of and even fewer understand. Will this be the next disaster? FORTUNE MAGAZINE [Time, Inc./Time Warner] - By Nicholas Varchaver, senior editor and Katie Benner, writer-reporter - September 30, 2008 As Congress wrestles with another bailout bill to try to contain the financial contagion, there's a potential killer bug out there whose next movement can't be predicted: the Credit Default Swap. In just over a decade these privately traded derivatives contracts have ballooned from nothing into a $54.6 trillion market. CDS are the fastest-growing major type of financial derivatives. More important, they've played a critical role in the unfolding financial crisis. First, by ostensibly providing "insurance" on risky mortgage bonds, they encouraged and enabled reckless behavior during the housing bubble. "If CDS had been taken out of play, companies would've said, 'I can't get this [risk] off my books,'" says Michael Greenberger, a University of Maryland law professor and former director of trading and markets at the Commodity Futures Trading Commission. "If they couldn't keep passing the risk down the line, those guys would've been stopped in their tracks. The ultimate assurance for issuing all this stuff was, 'It's insured.'" Second, terror at the potential for a financial Ebola virus radiating out from a failing institution and infecting dozens or hundreds of other companies - all linked to one another by CDS and other instruments - was a major reason that regulators stepped in to bail out Bear Stearns and buy out AIG (AIG, Fortune 500), whose calamitous descent itself was triggered by losses on its CDS contracts (see "Hank's Last Stand"). And the fear of a CDS catastrophe still haunts the markets. For starters, nobody knows how federal intervention might ripple through this chain of contracts. And meanwhile, as we'll see, two fundamental aspects of the CDS market - that it is unregulated, and that almost nothing is disclosed publicly - may be about to change. That adds even more uncertainty to the equation. "The big problem is that here are all these public companies - banks and corporations - and no one really knows what exposure they've got from the CDS contracts," says Frank Partnoy, a law professor at the University of San Diego and former Morgan Stanley derivatives salesman who has been writing about the dangers of CDS and their ilk for a decade. "The really scary part is that we don't have a clue." Chris Wolf, a co-manager of Cogo Wolf, a hedge fund of funds, compares them to one of the great mysteries of astrophysics: "This has become essentially the dark matter of the financial universe." *** AT FIRST GLANCE, credit default swaps don't look all that scary. A CDS is just a contract: The "buyer" plunks down something that resembles a premium, and the "seller" agrees to make a specific payment if a particular event, such as a bond default, occurs. Used soberly, CDS offer concrete benefits: If you're holding bonds and you're worried that the issuer won't be able to pay, buying CDS should cover your loss. "CDS serve a very useful function of allowing financial markets to efficiently transfer credit risk," argues Sunil Hirani, the CEO of Creditex, one of a handful of marketplaces that trade the contracts. Because they're contracts rather than securities or insurance, CDS are easy to create: Often deals are done in a one-minute phone conversation or an instant message. Many technical aspects of CDS, such as the typical five-year term, have been standardized by the International Swaps and Derivatives Association (ISDA). That only accelerates the process. You strike your deal, fill out some forms, and you've got yourself a $5 million - or a $100 million - contract. And as long as someone is willing to take the other side of the proposition, a CDS can cover just about anything, making it the Wall Street equivalent of those notorious Lloyds of London policies covering Liberace's hands and other esoterica. It has even become possible to purchase a CDS that would pay out if the U.S. government defaults. (Trust us when we say that if the government goes under, trying to collect will be the least of your worries.) You can guess how Wall Street cowboys responded to the opportunity to make deals that (1) can be struck in a minute, (2) require little or no cash upfront, and (3) can cover anything. Yee-haw! You can almost picture Slim Pickens in Dr. Strangelove climbing onto the H-bomb before it's released from the B-52. And indeed, the volume of CDS has exploded with nuclear force, nearly doubling every year since 2001 to reach a recent peak of $62 trillion at the end of 2007, before receding to $54.6 trillion as of June 30, according to ISDA. Take that gargantuan number with a grain of salt. It refers to the face value of all outstanding contracts. But many players in the market hold offsetting positions. So if, in theory, every entity that owns CDS had to settle its contracts tomorrow and "netted" all its positions against each other, a much smaller amount of money would change hands. But even a tiny fraction of that $54.6 trillion would still be a daunting sum. The credit freeze and then the Bear disaster explain the drop in outstanding CDS contracts during the first half of the year - and the market has only worsened since. CDS contracts on widely held debt, such as General Motors' (GM, Fortune 500), continue to be actively bought and sold. But traders say almost no new contracts are being written on any but the most liquid debt issues right now, in part because nobody wants to put money at risk and because nobody knows what Washington will do and how that will affect the market. ("There's nothing to do but watch Bernanke on TV," one trader told Fortune during the week when the Fed chairman was going before Congress to push the mortgage bailout.) So, after nearly a decade of exponential growth, the CDS market is poised for its first sustained contraction. *** ONE REASON THE MARKET TOOK OFF is that you don't have to own a bond to buy a CDS on it - anyone can place a bet on whether a bond will fail. Indeed the majority of CDS now consists of bets on other people's debt. That's why it's possible for the market to be so big: The $54.6 trillion in CDS contracts completely dwarfs total corporate debt, which the Securities Industry and Financial Markets Association puts at $6.2 trillion, and the $10 trillion it counts in all forms of asset-backed debt. "It's sort of like I think you're a bad driver and you're going to crash your car," says Greenberger, formerly of the CFTC. "So I go to an insurance company and get collision insurance on your car because I think it'll crash and I'll collect on it." That's precisely what the biggest winners in the subprime debacle did. Hedge fund star John Paulson of Paulson & Co., for example, made $15 billion in 2007, largely by using CDS to bet that other investors' subprime mortgage bonds would default. So what started out as a vehicle for hedging ended up giving investors a cheap, easy way to wager on almost any event in the credit markets. In effect, credit default swaps became the world's largest casino. As Christopher Whalen, a managing director of Institutional Risk Analytics, observes, "To be generous, you could call it an unregulated, uncapitalized insurance market. But really, you would call it a gaming contract." There is at least one key difference between casino gambling and CDS trading: Gambling has strict government regulation. The federal government has long shied away from any oversight of CDS. The CFTC floated the idea of taking an oversight role in the late '90s, only to find itself opposed by Federal Reserve chairman Alan Greenspan and others. Then, in 2000, Congress, with the support of Greenspan and Treasury Secretary Lawrence Summers, passed a bill prohibiting all federal and most state regulation of CDS and other derivatives. In a press release at the time, co-sponsor Senator Phil Gramm - most recently in the news when he stepped down as John McCain's campaign co-chair this summer after calling people who talk about a recession "whiners" - crowed that the new law "protects financial institutions from over-regulation ... and it guarantees that the United States will maintain its global dominance of financial markets." (The authors of the legislation were so bent on warding off regulation that they had the bill specify that it would "supersede and preempt the application of any state or local law that prohibits gaming ...") Not everyone was as sanguine as Gramm. In 2003 Warren Buffett famously called derivatives "financial weapons of mass destruction." *** THERE'S ANOTHER BIG difference between trading CDS and casino gambling. When you put $10 on black 22, you're pretty sure the casino will pay off if you win. The CDS market offers no such assurance. One reason the market grew so quickly was that hedge funds poured in, sensing easy money. And not just big, well-established hedge funds but a lot of upstarts. So in some cases, giant financial institutions were counting on collecting money from institutions only slightly more solvent than your average minimart. The danger, of course, is that if a hedge fund suddenly has to pay off on a lot of CDS, it will simply go out of business. "People have been insuring risks that they can't insure," says Peter Schiff, the president of Euro Pacific Capital and author of Crash Proof, which predicted doom for Fannie and Freddie, among other things. "Let's say you're writing fire insurance policies, and every time you get the [premium], you spend it. You just assume that no houses are going to burn down. And all of a sudden there's a huge fire and they all burn down. What do you do? You just close up shop." This is not an academic concern. Wachovia (WB, Fortune 500) and Citigroup (C, Fortune 500) are wrangling in court with a $50 million hedge fund located in the Channel Islands. The reason: A dispute over two $10 million credit default swaps covering some CDOs. The specifics of the spat aren't important. What's most revealing is that these massive banks put their faith in a Lilliputian fund (in an inaccessible jurisdiction) that was risking 40% of its capital for just two CDS. Can anyone imagine that Citi would, say, insure its headquarters building with a thinly capitalized, unregulated, offshore entity? That's one element of what's known as "counterparty risk." Here's another: In many cases, you don't even know who has the other side of your bet. Parties to the contract can, and do, transfer their side of the contract to third parties. Investment firms assert that transfers are well documented (a claim that, like most in the world of CDS, is impossible to verify). But even if that's true, you're still left with the fact that a given company's risks are being dispersed in ways that they may not know about and can't control. It doesn't help that CDS trading is a haphazard process. Most contracts are bought and sold over the phone or by instant message and settled manually. Settlement has been sloppy, confirms Jamie Cawley of IDX Capital, a firm that brokers trades between big banks. Pushed by New York Fed president Timothy Geithner, the players have been improving the process. But even as recently as a year ago, Cawley says, so many trades were sitting around unfulfilled that "there were $1 trillion worth of swaps that were unsettled among counterparties." Trade settlement is not the only anachronistic aspect of CDS trading. Consider what will happen with CDS contracts relating to Fannie Mae and Freddie Mac. The two were placed in conservatorship on Sept. 7. But the value of many contracts won't be determined till Oct. 6, when an auction will set a cash price for Fannie and Freddie bonds. We'll spare you the technical reasons, but suffice it to ask: Can you imagine any other major market that would need a month to resolve something like this? *** WITH WASHINGTON SUDDENLY in a frenzy of outrage over the financial markets, debating everything from the shape and extent of the mortgage plan to what should be done about short-selling, the future for CDS is very blurry. "The market is here to stay," asserts Cawley. The question is simply: What sorts of changes are in store? As this article was going to press, SEC chairman Christopher Cox asked the Senate to allow his agency to begin regulating CDS - mostly, it should be said, to rein in short-selling. And the SEC separately announced that it was expanding its investigation of market manipulation, which initially targeted the short-sellers, to CDS investors. Under other circumstances, Cox's request might have been met with polite silence. But the convulsions over the mortgage bailout are so dramatic that they are reminiscent of the moment, soon after the Enron scandal, when Congress drafted the Sarbanes-Oxley legislation. The desire to blame short-sellers may actually result in powers for Cox that, until very recently, he showed no signs of wanting. Should legislators wade into this issue, the measures most widely seen as necessary are straightforward: some form of centralized trading or clearing and some form of capital or reserve requirements. Meanwhile, New York State's insurance commissioner, Eric Dinallo, announced new regulations that would essentially treat sellers of some (but not all) CDS as insurance entities, thereby forcing them to set aside reserves and otherwise follow state insurance law - requirements that would probably drive many participants from the market. Whether CDS players will find a way to challenge the rules remains to be seen. (ISDA, the industry's trade group, has already gone on record in opposition to Cox's proposal.) If nothing else, the New York law may provide additional impetus for the feds to take action. For now, the biggest impact could come from the Financial Accounting Standards Board. It is implementing a new rule in November that will require sellers of CDS and other credit derivatives to report detailed information, including their maximum payouts and reasons for entering the contracts, as well as assets that might allow them to offset any payouts. Anybody who has tried to parse CEO compensation in recent years knows that more disclosure doesn't guarantee clarity, but any increase in information in the CDS realm will be a benefit. Perhaps that would limit the baleful effect of CDS on (must we consider it?) the next disaster - or even help us prevent it. http://money.cnn.com/2008/09/30/magazines/fortune/varchaver_derivatives_short.fortune/index.htm FAIR USE NOTICE: This blog contains copyrighted material the use of which has not always been specifically authorized by the copyright owner. We are making such material available in our efforts to advance understanding of religious, environmental, political, human rights, economic, democracy, scientific, and social justice issues, etc. We believe this constitutes a 'fair use' of any such copyrighted material as provided for in section 107 of the US Copyright Law. In accordance with Title 17 U.S.C. Section 107, the material on this site is distributed without profit to those who have expressed a prior interest in receiving the included information for research and educational purposes. For more information go to: http://www.law.cornell.edu/uscode/17/107.shtml. If you wish to use copyrighted material from this site for purposes of your own that go beyond 'fair use', you must obtain permission from the copyright owner.