Sunday, September 21, 2008

Credit Derivatives Swamp Wall Street

Credit default swaps are Wall Street's method of granting peace of mind to large credit holders. Those instruments soared in price as word of investment house troubles spread. The Wall Street Journal reported:

In the past week, a jump in the value of credit-default swaps tied to Morgan Stanley and Goldman Sachs Group Inc. set off similar concerns at both firms. On Thursday morning, swap sellers were charging buyers more than $900,000 annually to insure $10 million of Morgan Stanley's obligations from default over five years, a price typically associated with highly risky or distressed companies. The prices had doubled from Monday and tripled from the week before. On Friday, after the SEC announced its short-selling curbs, the cost fell to $560,000.

After the government took action the price of the Morgan Stanley credit default swap dropped to 28% over a five year period. Lenders need to pass such costs on, causing a huge rise in interest rates. A 5% jump overnight would kill credit.

Not having peace of mind via some insurance mechanism? That also kills credit in this panicky market.

Unregulated credit derivatives are a huge problem for our economy. That's the financial innovation cited by President Bush and John McCain. On 60 Minutes Republican candidate McCain said he didn't regret financial deregulation, saying it was "probably helpful to the growth of the economy."

Sorry John, I don't see how off balance sheet trading of legal gambles, like derivatives, "helps the growth of the economy." They're currently clogging the air intake of our financial sector. With that locked up, it won't take long for the engine to choke off and die. Let's hope credit default swaps aren't the motor oil. A restart is much better than a complete rebuild. Goldman Sachs and Morgan Stanley are trying a restart as bank holding companies.