Financial Weapons of Mass Destruction
May 6, 2010
Posted by Jody Eisenman | Filed under Uncategorized
Before I get to today’s topic, I would be remiss if I didn’t address what is going on in the financial markets. After an almost spectacular one year uptrend, we are finally getting the much overdue correction. Between April 14 and April 29, the DJIA went essentially nowhere. However, in the last four trading days, the index has given up about 300 points, and that includes the 150 point gain on Monday. What seems to be driving the market is the European situation. Greece is in deep trouble, and today the riots in the streets were shown all over CNN and CNBC. To add to the woes, Portugal is on credit watch from Moody’s for a potential downgrade, and there are rumors floating around about Spain as well. As such, the Euro is getting absolutely clobbered in the currency markets. Currently, one euro will buy approximately $1.28, which is a 13 month low. Remember the VIX, which is a volatility index? It was below 16 on April 20. Today, it has soared to almost 25.
I believe this correction to be healthy, but its’ always painful when it happens. On a chart, the Dow probably has support around 10,500, and strong support around 10,000. If it were to break those levels (which I do not expect to happen), it could get ugly. The only way I could see that happening is in the event of a disastrous totally unforseen event.
Now to the title of today’s blog post. Back in 1988, Warren Buffets’ company Berkshire Hathaway, purchased General Reinsurance for $22 billion. At the time, it was the largest property and casualty reinsurer in the United States. One of the divisions of the company had substantial derivative exposure to the global financial markets. When Buffet tried to sell this division, he found that there were no buyers. He then referred to these instruments as “financial weapons of mass destruction”. At that time, the largely unregulated derivatives market was not believed to be dangerous. By 2008, the market had grown to over $500 TRILLION. To put this number in prospective, the United States had a total Gross Domestic Product (GDP) of $14.3 trillion last year. Thus, the derivatives market is over 30 times the size of the worlds’ largest economy.
We know that the government bailed out AIG starting in 2008. For some color on this, please read: http://www.jodyeisenman.com/2010/01/the-backdoor-bailout/
and
http://www.jodyeisenman.com/2009/12/how-close-did-we-get-to-the-brink/
Here’s the fun part: Starting in 2007, some sharp hedge funds perceived that the CDOs created by the banks were in trouble. They wanted to buy CDS, which were basically put options that get paid off 100 cents on the dollar in the case of default of the underlying instrument. AIG decided to underwrite billions of these at a cost of between 15 and 25 basis points per year. In other words, an investor could bet on a specific CDO default by paying around $2 per year for every thousand. Why was the cost so cheap? Because AIG viewed these AAA rated instruments as virtually risk free. They were very happy to collect these premiums, figuring that a default would be almost impossible. Of course, we now know how wrong both AIG and the ratings agencies were. However, the story doesn’t end there. These hedge funds had no access to AIG. They did, however, have accounts at Goldman Sachs. Goldman purchased these CDS from AIG, and resold them to these funds at an average price of 200-250 basis points. In other words, they marked this paper up by as much as 1000%! By some estimates, Goldman was taking in several hundred million dollars per year in essentially riskless trades!
Unfortunately, when it became apparent that many of these CDOs would default, the funds that made the bet were due a tremendous amount of money. Unfortunately for AIG, they barely reserved any money for this, which is roughly analogous to an insurance company taking your premiums every year for life insurance that they had no ability to pay off if you die. Here’s where it gets interesting (or ugly, depending on what side of the trade you were on). The hedge funds had made this bet with Goldman Sachs ( as well as many of the other large banks). They didn’t know or care anything about AIG or its’ problems. Therefore, Goldman was legally on the hook for this. If AIG defaulted, guess who had to come up with the money? Now you can understand why Goldman and the other banks were so desperate for AIG to be bailed out. Without the billions from the federal government, they could have been facing potential bankruptcy. Pretty scary, isn’t it?
