More thought, less sense.

Greed -- while good -- is probably the genesis of the Fiasco. This makes these crises inevitable ... given the human condition. No matter how clever we think ourselves, we still manage to find a way to screw up. And the more I reflect on and learn about the interconnection of the financial markets, the more I am convinced that we are definitely too clever for our own boots.

Fundamentally, the markets have too much debt out there. Simply too much borrowed or pledged, which in turn permits expansion, profits and human advancement ... greed for more. I believe I may have heard someone on CNBC (although I heard last night maybe it was NPR?!) opine just about the same thing --- so I can't claim original thought here. And certainly every business newspaper or magazine has long articles on the same subject, but I feel the need.

And in thinking about too much debt, I am again struck by the sheer magnitude of the Credit Default Swap, or CDS risk.... Could CDSs be culprit #1? Sure mortgages might have been the trigger that brought the house down, but maybe they are merely symptomatic of "too much debt." Consider CDSs ... essentially, they are insurance that covers against a given bond (or counterparty) going into default. Being unable to meet the terms of the bond (or debt servicing or what have you) causes the insurance to be triggered: you buy an XYZ Corp. commerical bond from, say, Lehman and then you buy a CDS from Citi -- you pay a certain percentage of the face value of the bond to Citi. When XYZ defaults, the writer, Citi, owes you the face value. Voila, insurance. Nice and easy, safe too.

All this seems pretty normal, except that in the CDS market, other people can insure themselves against risks they don't have: I can buy insurance on the XYZ bond, even though I do not own it. Another way of looking at this is this: I can buy insurance against a fire at YOUR house, or on YOUR life while being completely unconnected to you ... I might not even know you or that you exist, except that some slimeball CDS salesperson offered the contract on your life to me. When I used to be a trader at Citi, we had an interesting pool ... sort of like your March Madness, except that it was called the "Ghoul Pool." Various brokers were in on it too, if I recall. The idea was we all threw in $20 betting on which famous person was going to die next. In hindsight, it was a CDS market. I remember people betting on Mother Theresa, Bob Hope, Jimmy Durante for age, various rock stars in the expectation of an overdose ... you get the idea.

Back to business.

Against $5 trillion or so of outstanding bonds, some $60 trillion of insurance has been written against it. And the writers of the insurance are emphatically not able to cover the risks they have insured ... and that is why Lagarde wet herself getting Paulson to bail AIG. AIG couldn't possibly cover its risks in a systemic failure and the counterparties that then sold or netted their AIG risk against other counterparties can't cover their risks either. You see, nobody knows against who a given risk may have been laid off against. This sort of problem is nothing new, I can recall considering the whole mess of currency options and the outstanding notional against some pretty pathetic counterparties (Drexel anyone?).

While everyone was/is secure, and there was/is good netting ... you get low counterparty default risk. But with some of the largest players in the CDS market not very good credit risks ... you get a large problem. Hedge funds with 500 million to a billion in assets wrote policies (entered into CDS agreements) for hundreds of billions. While the subject of the CDS remained in good order, no problem, and the hedge fund earned millions on its bet (selling the CDS). But when Bear Stearns went down the tubes, the hedge funds couldn't cover. Worse, the banks that depended on the coverage from the hedge funds didn't get it ... leading to a capital requirement that they didn't have ... or struggled to meet.

Which explains why the Fed let Lehman tank and not Bear Stearns -- the Bear was a huge player in the CDS market: small capital supporting huge risk. It may also explain why banks and other financial firms that should be able to meet their capital requirements with a surplus left over to lend out ... can't and aren't. The whole CDS market was/is completely unregulated. Any attempts and suggestions were shot down -- quickly (2002 the CFTC tried to extend jurisdiction, but failed and various legislators have tabled suggestions) with the assistance of lobbyists here and around the globe. The scam was simpy too good to pass up. Again I think of the word "Ponzi."

Worse still, there still isn't any way to assess a potential counterparty's exposure to CDSs except to ask: it becomes a "full faith" crapshoot. Which bank is going to open its Kimono to the other? "Lemme see how stupid you have been and I will show you how stupid I have been. Then we can negotiate to see if we might not start lending to each other again?" It may have to happen exactly like that. That is precisely what JP Morgan did that night early in the 20th Century during a banking panic. The trouble is ... JP is dead.

All this is not to say that CDSs are not useful. The CDS market reflects to a highly sophisticated degree the market's estimation of a particular counterparty's risk. If your CDS rate goes up, it reflects the fact that the market considers you to be an increasing risk. Like watching your name get listed on the Ghoul Pool.

There are moves afoot to establish a clearing house for CDSs, which should serve to address risks outstanding, for the benefit of all to see. But right now ... would you bet on a hedge fund to insure you? And there is absolutely nobody around to assess the creditworthiness of the hedge fund? Consider some small dodgy bank (with lots of Brunei oil money) in Jakarta, sells a CDS to a larger bank in Kuala Lumpur. That risk was first purchased in Jakarta from a hedge fund located in the Caymans but run out of New York -- sold by a Master of the Universe. The KL bank then nets that CDS out with ... Soc Gen in Paris. The hedge fund makes lots of silly bets that Lehman couldn't be allowed to fail ... "its too big, just like the Bear, so buy its paper." Ooops. And because of netting agreements, Soc Gen is left holding the bag? Because Soc Gen had no way of knowing that the end of the domino chain was a 20-something weenie behind a screen in a high tech office in Tribeca? Er?

So some bank or other lends too much on real estate, gets caught as the CDO mess starts to cave and then watches its CDS rate skyrocket ... then fail altogether. The run is on. AIG might be the ultimate example yet uncovered. Truly too big to fail, because of a little known product, but with trillions outstanding. Many trillions. Many trillions more that the total face value of mortgages outstanding in the United States. Ouch.

Just a thought, mind you, just a thought. And if you want to find a safe place to stash money, make sure your bank didn't have a CDS desk. This might wind up making the subprime mess just a sideshow.