Woman Who Invented Credit Default Swaps is One of the Key Architects of Carbon Derivatives

Washington's Blog

As I have previously shown, speculative derivatives (especially credit default swaps or "CDS") are a primary cause of the economic crisis. They were largely responsible for bringing down Bear Stearns, AIG (and see this), WaMu and other mammoth corporations.

According to top experts, risky derivatives were not only largely responsible for bringing down the American (and world) economy, but they still pose a substantial systemic risk:

• A Nobel prize-winning economist (George Akerlof) predicted in 1993 that CDS would cause the next meltdown

• Warren Buffett called them “weapons of mass destruction” in 2003

• Warren Buffett’s sidekick Charles T. Munger, has called the CDS prohibition the best solution, and said “it isn’t as though the economic world didn’t function quite well without it, and it isn’t as though what has happened has been so wonderfully desirable that we should logically want more of it”

• Former Federal Reserve Chairman Alan Greenspan - after being one of their biggest cheerleaders - now says CDS are dangerous

• Former SEC chairman Christopher Cox said "The virtually unregulated over-the-counter market in credit-default swaps has played a significant role in the credit crisis''

• Newsweek called CDS "The Monster that Ate Wall Street"

• President Obama said in a June 17 speech on his plans for finance industry regulatory reform that credit swaps and other derivatives “have threatened the entire financial system”

• George Soros says the market is still unsafe, and that credit- default swaps are “toxic” and “a very dangerous derivative” because it’s easier and potentially more profitable for investors to bet against companies using them than through so-called short sales.

• U.S. Congresswoman Maxine Waters introduced a bill in July that tried to ban credit-default swaps because she said they permitted speculation responsible for bringing the financial system to its knees.

• Nobel prize-winning economist Myron Scholes - who developed much of the pricing structure used in CDS - said that over-the-counter CDS are so dangerous that they should be “blown up or burned”, and we should start fresh

• A leading credit default swap expert (Satyajit Das) says that the new credit default swap regulations not only won't help stabilize the economy, they might actually help to destabilize it.

• Senator Cantwell says that the new derivatives legislation is weaker than current regulation
  

Round Two: Carbon Derivatives

Now, Bloomberg notes that the carbon trading scheme will be largely centered around derivatives:

The banks are preparing to do with carbon what they’ve done before: design and market derivatives contracts that will help client companies hedge their price risk over the long term. They’re also ready to sell carbon-related financial products to outside investors.

[Blythe] Masters says banks must be allowed to lead the way if a mandatory carbon-trading system is going to help save the planet at the lowest possible cost. And derivatives related to carbon must be part of the mix, she says. Derivatives are securities whose value is derived from the value of an underlying commodity -- in this case, CO2 and other greenhouse gases...

Who is Blythe Masters?

She is the JP Morgan employee who invented credit default swaps, and is now heading JPM's carbon trading efforts. As Bloomberg notes (this and all remaining quotes are from the above-linked Bloomberg article):

Masters, 40, oversees the New York bank’s environmental businesses as the firm’s global head of commodities...

As a young London banker in the early 1990s, Masters was part of JPMorgan’s team developing ideas for transferring risk to third parties. She went on to manage credit risk for JPMorgan’s investment bank.

Among the credit derivatives that grew from the bank’s early efforts was the credit-default swap.

Some in congress are fighting against carbon derivatives:

“People are going to be cutting up carbon futures, and we’ll be in trouble,” says Maria Cantwell, a Democratic senator from Washington state. “You can’t stay ahead of the next tool they’re going to create.”

Cantwell, 51, proposed in November that U.S. state governments be given the right to ban unregulated financial products. “The derivatives market has done so much damage to our economy and is nothing more than a very-high-stakes casino -- except that casinos have to abide by regulations,” she wrote in a press release...

However, Congress may cave in to industry pressure to let carbon derivatives trade over-the-counter:

The House cap-and-trade bill bans OTC derivatives, requiring that all carbon trading be done on exchanges...The bankers say such a ban would be a mistake...The banks and companies may get their way on carbon derivatives in separate legislation now being worked out in Congress...

Financial experts are also opposed to cap and trade:

Even George Soros, the billionaire hedge fund operator, says money managers would find ways to manipulate cap-and-trade markets. “The system can be gamed,” Soros, 79, remarked at a London School of Economics seminar in July. “That’s why financial types like me like it -- because there are financial opportunities”...

Hedge fund manager Michael Masters, founder of Masters Capital Management LLC, based in St. Croix, U.S. Virgin Islands [and unrelated to Blythe Masters] says speculators will end up controlling U.S. carbon prices, and their participation could trigger the same type of boom-and-bust cycles that have buffeted other commodities...

The hedge fund manager says that banks will attempt to inflate the carbon market by recruiting investors from hedge funds and pension funds.

“Wall Street is going to sell it as an investment product to people that have nothing to do with carbon,” he says. “Then suddenly investment managers are dominating the asset class, and nothing is related to actual supply and demand. We have seen this movie before.”

Indeed, as I have previously pointed out, many environmentalists are opposed to cap and trade as well. For example:

Michelle Chan, a senior policy analyst in San Francisco for Friends of the Earth, isn’t convinced.

“Should we really create a new $2 trillion market when we haven’t yet finished the job of revamping and testing new financial regulation?” she asks. Chan says that, given their recent history, the banks’ ability to turn climate change into a new commodities market should be curbed...

“What we have just been woken up to in the credit crisis -- to a jarring and shocking degree -- is what happens in the real world,” she says...

Friends of the Earth’s Chan is working hard to prevent the banks from adding carbon to their repertoire. She titled a March FOE report “Subprime Carbon?” In testimony on Capitol Hill, she warned, “Wall Street won’t just be brokering in plain carbon derivatives -- they’ll get creative.”

How the Movie Ends

Yes, they'll get "creative", and we have seen this movie before ...an inadequately-regulated carbon derivatives boom will destabilize the economy and lead to another crash.

I have previously pointed out that CDS sellers - like the big sellers of other financial products - know that the government will bail them out if CDS crash again. So they have strong incentives to sell them and to recreate huge levels of leverage. Indeed, the same dynamic that led to the S&L crisis also led to last year's CDS crisis, and will lead to the next crisis as well. So - while CDS might be a particularly dangerous type of "weapon of mass destruction" (in Warren Buffet's words), the new carbon derivatives may very well become the new form of looting on the public's dime. If the government allows massive carbon derivatives trading with as little oversight as over the CDS market, taxpayers will end up spending many trillions bailing out the giant banks and propping up the economy when the carbon market bubble bursts.

And as I have previously pointed out: (1) the giant banks will make a killing on carbon trading, (2) while the leading scientist crusading against global warming says it won't work, and (3) there is a very high probability of massive fraud and insider trading in the carbon trading markets.

BLS Non-Farm Payroll Survey: smoke, mirrors, bias and outright falsehoods

Ilargi at The Automatic Earth
Drowning by the numbers
No doubt there are people who see this week's BLS Non-Farm Payroll survey as "not good, but not all that bad either". They can point for instance to the fact that the 85,000 jobs lost according to the report is much better than the 800,000 jobs lost back in March 2009.

The Wall Street Journal puts it like this: ”Even though the payroll number was worse than expected, the data reflects an improvement in the jobs market.”.

But unfortunately, this is all smoke, mirrors, bias and outright falsehood. The Household part of the monthly BLS survey mentions 465,000 lost jobs. 647,000 full time jobs left the building. But that's not even remotely where the true problem lies.

The reason why unemployment, as per the Household survey, stayed at 10% and "only" 85,000 jobs are reported MIA in the Payroll survey can be found in the labor force numbers. From November to December 2009, the "persons not in the labor force" category went up by 843,000 (over 1 million when not seasonally adjusted), and now stands at 83,865,000. The vast majority of those singing off, i.e. not actively looking for work, are people who can't see any jobs anywhere in their environment. The worse the economy gets, the fewer people are counted as unemployed. It’s a lovely invention, but it's also am awfully perverted one.

That is also true for seasonal adjustments in other categories. It’s estimated that that actual initial claims numbers may be double what's reported, simply because the models used are too rigid to take into account present economic conditions. A similar idea is true for continuing claims. Michael Widner at Stifel, Nicolaus says:

”We could conceivably have nearly 11 million people collecting unemployment and see the data reported as a 3.something million figure."

U6 unemployment is up. Average and median unemployment duration is up on all counts. The amount of people without a job for more than half a year is soaring, and these people now form 40% (6.1 million) of the total unemployed. The employment to population ratio fell to 58.2%, the lowest in at least 27 years. The national payroll level went from 130.8 million in 2000 to 130.9 million today. 100,000 jobs added for the 13 million people who were added to the "available" labor pool. In other words, 13 million unemployed were added.

Extended benefits and Emergency Unemployment Compensation, the two programs set up for the long-time jobless, are bursting through their seams. A slight decrease in initial and continuing jobless claims may seem to indicate something positive, but the reality is that people don't leave these programs because they find jobs, but because they've exhausted their benefits and are forced into extended and emergency programs. There are strong suggestions that the latter grew by some 43% in just the past month.

And though we've seen no mention of it this week, we haven't forgotten that the BLS "owes" us the 824,000 jobs they "forgot" to count till March 2009.

No matter where you stand, no matter what you see the economy doing in 2010, it should be clear to everyone who can read by now that reporting on unemployment in the US is a god-forsaken mess, strongly biased towards what pleases Washington, i.e. numbers much lower than the real ones. That said, while many citizens may still be fooled by the official data, you can bet that Washington knows perfectly well what the real numbers are, and many hours of backroom meetings are dedicated to the topic. How much of that reflects genuine care for constituencies, and how much mere worry about election numbers, we’ll leave up to you to ponder.

The same mentality that leads to the severely distorted jobs numbers speaks loudly from the AIG files, that increasingly question Tim Geithner role in the $100+ billion handed to Goldman Sachs et al as 100% compensation for lost credit default swaps wagers. And that, predictably, leads to calls for the resignation of Geithner.

But we've seen similar calls for Ben Bernanke and Larry Summers to resign. And they're still there. Moreover, what difference would it make to remove one of them and leave the others be where they are? If you don't clean up for real, why bother? It becomes just another silly game that way, doesn't it?

Reminds me of a man named Travis Bickle, who said some 35 years ago:

"All the animals come out at night - whores, skunk pussies, buggers, queens, fairies, dopers, junkies, sick, venal. Someday a real rain will come and wash all this scum off the streets."

Credit Default Swaps Linked to US, UK and Japan Double

David Oakley
Bets rise on rich country bond defaults
The mounting level of debt in the industrialised world is prompting a growing number of investors to use the derivatives market to bet on the chance of rich governments defaulting on bonds.

Public debt and CDS volumesThe volume of activity in sovereign credit default swaps – which measure the cost to insure against bond defaults – linked to the US, UK and Japan have doubled in the past year because of concerns about their public finances.

CDS volumes for Italy, which has one of the highest debt burdens of the developed economies, are now the highest for an individual country, according to the Depository Trust & Clearing Corporation.

In contrast, the outstanding volume of CDS linked to emerging nations such as Russia, Brazil, Ukraine and Indonesia have been flat or fallen in the past 12 months as investors have become less interested in trading the risks of those countries.

In the past, the CDS market for developed countries was sluggish, because few investors saw the need to buy or sell protection against a risk of default that seemed exceedingly remote.

However, rising debt levels and growing political and economic uncertainty have created a more active market, with more investors now seeking insurance. Meanwhile, many banks are prepared to offer protection in exchange for a fee.

This fee has recently jumped, since the cost to insure the debt of developed countries has increased since the summer of last year, while the cost of insuring emerging market debt has fallen.

Gary Jenkins, head of fixed income research at Evolution, said: “The biggest single risk hanging over the bond markets is the rapid rise in public debt in the industrialised world.

“If we get to a point where the market thinks the levels of debt are unsustainable, then we will see an almighty sell-off in the government bond markets, with yields soaring. Governments need to take action to cut deficits and debt.”

Fitch Solutions, the data arm of the Fitch Group, said that there was almost as much uncertainty in the CDS market about the outlook for the developed economies and their bond markets as there was for emerging economies.

Comparisons between Italy and Brazil are often used by strategists as an example of the contrasting fortunes of the developed and emerging world.

Italy’s ratio of debt to gross domestic product is forecast to rise to 127.3 per cent in 2010.

On the other hand, Brazil’s debt-to-GDP ratio is forecast to stabilise at 65.4 per cent in 2010.

Nigel Rendell, senior emerging markets strategist at RBC Capital Markets, said: “It is not surprising that investors are increasingly worried about debt in the industrialised world. Debt to GDP of more than 100 per cent is difficult to sustain.”