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Credit Default Swaps Rise From The Ashes

Financial Phoenix
3 minute read

The mythological Phoenix represents an endless cycle. It lives, dies, then rises from its ashes again and again. This imagery also describes the cyclical nature of the financial markets, like in the case of Credit Default Swaps. The metaphor also applies to the semi-periodic occurrence of economic depression as well as the mindset and behavior of market participants. The market will often completely lose its faith in a specific asset, only to re-discover it with renewed enthusiasm later on.

Global financial markets were shaken to their core in 2008, when the subprime mortgage crisis rippled out of the US & UK. The fall of banks, brokerages and other financial institutions also caused real estate prices to plummet. Its effects were felt by real estate owners across the world, especially those who financed their purchases through loans. Prices dropped so low that the best course of action for borrowers was to simply cut their losses and default. The repossessed properties often lost 60-70% of their original value by the time they ended up with the banks.

There were many factors that contributed to the escalation of the 2008 crisis, however, the one that received the most scrutiny was subprime lending. Up to that point most people didn’t know what Credit Default Swaps were, until they suddenly became the center of attention. The idea was to re-package subprime mortgage bonds into regulated over the counter securities and then cover the risk of default by purchasing Credit Default Swaps. At the time it seemed like a perfect risk-free construct. Unfortunately the process of transforming these mortgages into tradable securities has made them too far removed from the actual real estate market. As the rate of defaults on these mortgages swelled to a sizable percentage, the securities they were bundled into started losing value. This made the institutions issuing these securities to go bankrupt. When they did, it fell to the banks or insurance companies who released the Credit Default Swaps to cover them. These companies were unprepared for the sheer volume of payments they’d have to make, causing them to go down as well. The list of financial institutions that fell victim to this pattern include Fannie Mae, Freddie Mac, AIG, Lehman Brothers, Citibank, and Bear Stearns, just to no name a few.

Common sense suggests anyone who’s seen the events of 2008 play out would go out of their way to avoid such an unsuccessful investment construct. In reality that doesn’t seem to be the case. The subprime mortgage and Credit Default Swaps combination is experiencing a vigorous resurgence. It may come in a different form, but the underlying concept is the same. The other difference is that the US isn’t ground zero this time, it’s actually happening in the world’s second largest economy: China.

The phenomenon isn’t limited to the real estate market, it also extends to corporate loans. It’s also not exclusively financed by the regulated banking industry, but also by China’s so called shadow banking system. They’re loans coming from private companies or individuals rather than China’s commercial banking system or state run banks. The situation is further complicated by the lack of information on the amount of capital circulated by the shadow banking system. What we do know for a fact is that they package these dubious unregulated loans into special financial assets with the help of banks, who then resell them as tradable securities. The result is that not even the banks themselves know exactly what they’re selling and if this gives you a strong sense of deja vu, you’re not alone.

Neither foreign investors nor the Chinese government knows the exact number and size of these loans. Some estimates say they make up as much as two thirds of all lending in China. On the other hand we can’t even begin to estimate the number or ratio of defaults. In spite of that, the number of subprime mortgage bonds continues to increase. Today these bonds can be found on the shelves of financial institutes across the world in over 1,000 billion dollars worth of combined value. Although it’s easy to dismiss as having nothing to do with us, doing so would be a mistake. These bonds are often part of high-yield ETFs, since they’re closely involved in the bundling and re-packaging of these loans. What makes it even more worrying is that these subprime loans will eventually reach critical mass just like they did in 2008. If China’s growth prospects decline, it could drag down the entire world economy with it.

The rising of the mortgage-backed security Phoenix shows us that investors are more than willing to give shunned old assets a second chance as long as they come with a new coat of paint. Let’s just hope this one doesn’t turn into the chicken that comes home to roost.

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