The Western World Held Hostage by the Banksters Exposure to OTC Derivatives (Credit Default Swaps)

...from Institutional Risk Analytics, by Dick Alford

As we told our friends on CNBC's Fast Money last week, the apparent bailout for the EU banks led by BNP, Societe General and the German landesbanks is shared equally by their US derivatives counterparts. Remember, as of the end of Q1 2011, it would take just a move of less than 10bp in the aggregate value of the OTC derivatives book of JPMorgan Chase (JPM/Q1 2011 Bank Stress Rating: "B") to wipe out the firm's capital.

So the more accurate description is that all of the major players in the world of credit default swaps were bailed out on Friday, proof again that this financial ghetto known as OTC derivatives is adding to the systemic risk problem -- and holds the entire world hostage.

The net increase in financial exposures due to the existence of the CDS market in sovereign credit risk has not made the real economy safer, but instead multiplies the dollar amount of the basis risk in all markets, real or imagined. You cannot get rid of systemic risk and "too big to fail" until you limit credit derivative products to holders of actual debt. Instead we have hedge funds and banks gambling on the end of the world.

The impending damage of a mark-to-market event with respect to Greece or Ireland is such that the craven fools who inhabit public offices from Paris to Washington are forced to socialize the losses of the banks. The free market is dead and we have all arrived at a sort of involuntary socialism, where the largest banks rape and pillage, and even hedge funds and other credulous players in the financial markets are turned into victims.

This grotesque situation reminds us of the comment made by our friend Walker Todd at AIER, who suggested that governments should simply underwrite all commercial risk exposures and by law exclude all other claims from any safety net. The remaining "speculative" financial activity in things like CDS contracts would be specifically banned from the banking sector. This eliminates the need for governments to worry about who is the dumbest guy in the room, to paraphrase author Martin Mayer on this question.

The thing people need to appreciate is that the large banks today with respect to exposure to Greece and Ireland are in precisely the same position as was American International Group in 2007. In that case, AIG had written excessive credit insurance on mortgage backed securities in order to generate fictitious income. This financial fraud eventually collapsed, forcing the Fed of New York under Timothy Geithner to come riding to the rescue of JPM, Goldman Sachs ("GS") and their derivatives counterparties in Europe because AIG could not make good on its liabilities.

In the most recent case, the major dealer banks in the EU end US have created mountains of new credit risk with respect to Greece and Ireland by selling insurance to their clients, both commercial hedgers and speculators. The latter group is far larger than the true commercial hedging needs for risk management, a side benefit of the expansionary policies of the Fed under Alan Greenspan and now Ben Bernanke. Thus the original sin of monetary accommodation by the Fed comes back to haunt us all in the form of an uncontrolled market panic fueled by cash settlement credit derivatives.

The refusal of the political class to imposes losses on large bank creditors since the collapse of Lehman Brothers and Washington Mutual in 2008 illustrates the extent to which the financialization of the western industrial economies has turned into a gradual coup d'etat by the banks and the global speculators who dominate their client base. The CDS market specifically has become so large and threatening that the politicians are even forced to renege on bets against Greece by the largest and most important bank clients.

So much of what goes on inside the typical investment bank today has nothing to do with the real economy as illustrated by the Greek situation. Much of finance today is beggar they neighbor speculation. But even the hedge funds that were betting on raging contagion are getting stiffed by the banksters and their political sponsors. Just as individual savers are being denied their due via low rate policies, the speculative class is also being stiffed by banks that cannot make good on their wagers in CDS.

By saying that the banks and their creditors cannot be made to take losses on even their speculative activities, technocrats such as Germany's Angela Merkel, France's Nicholas Sarkozy and Barack Obama have become the ambassadors for the new global ruling class. The servants of the banksters, Sarkozy, Merkel and Obama, think that they can put the entire weight of restructuring Europe and US debt on the backs of taxpayers. 

Do our leaders really think that they can restructure Greece and Ireland via austerity without requiring any pain from investors in bank debt or the managers of the banks? If so, then the decision on Friday is not a solution but instead puts the western market economies on the road to further political and financial turmoil. Just as the unfair peace after WWI led to economic depression in Europe and the rise of fascism, the decision to dispense with the pretense of free market discipline in the industrial economies puts us all on the road to serfdom and political upheaval.