Before getting to the very interesting article that follows, let me take a moment to tell you about this week. On Monday, 10/6, and Tuesday, 10/7, we were in Las Vegas for our 2nd Annual Asset Protection forum.
John Dietz, CWPP™, CAPP™, a co-founder of the Asset Protection Society was in attendance. John wrote this article and I would like to pass it along to you as it is a timely article addressing one of the main concerns for, not only all of our members and attendees, but, for all of us today.
Now to John’s article.
Is My Money Safe With Big Companies?
By John Dietz
Date: October 6, 2008
What a ride the financial markets have been. The bottom line that most Americans want to know is:“Is my money safe?”
|As much as we crave security, the bottom line answer does not solve the problem. Safe today is not necessarily safe tomorrow. Why did this financial meltdown transpire throughout the world with such great consequences to the United States?|
During the development of the so-called rescue plan, I attended several conferences offshore while visiting clients throughout Asia. As I saw the rescue development unfold through foreign media, I got a good dose of the global perspective.
If there is a global meltdown, no one has told the Chinese. They were busy celebrating their independence week while the markets were gobbling up banks like a Pac-Man game. While on the main shopping street in Beijing, locals watched massive outdoor television screens with the first landing of a Chinese manned space flight seemingly oblivious to market problems. Equally impressive to exemplify how many people share this global market was a visit to Tiananmen Square and the Forbidden City on a Chinese holiday.
To the Point
My motivation for writing today is to forewarn you that fear can be a motivator, however, don’t make it the perpetuating emotion behind any transactions you may conduct right now regarding your finances. In fact, if you have been listening to the U.S. media, there is a good chance you are confused and have already put what money you have left under the mattress.
Let’s get to the cornerstone credit problem that threatens day-to-day cash flow in the world. Major banks, insurance companies and large corporations all participate in this transaction of corporate cash flow trading, now suspected to be detrimental to our financial stability.
Credit Default Swapping (CDS)
Regarding finance, a credit derivative in the Credit Derivative Obligation market (CDO) is a derivative whose value is derived from credit risk. (It is like betting that you will NOT lose or default.) The risk is absorbed by a bond, loan or combination of financial assets with a very low bond value to asset ratio.
A Credit Derivative Swap, CDS, provides insurance for a default by a company of sovereign entity. A CDS is a credit derivative contract between a buyer and a seller.
- The company is the reference entity
- The default is the credit event
- The buyer is the one who obtains the right to sell a bond issued by the reference entity for its face value if a credit event (default) occurs.
- The rate of payments made per year is known as the CDS Spread of either face value (par) or the difference between face value and market value.
To give you some idea of how big this market is, the U.S. alone reports outstanding credit from banks to be $16.4 trillion, and the world reports trading $42.6 trillion. The numbers show a credit craving United States. The giants that you have seen in the “rescue” all participate in this trading. Credit ratings by Moodys and the S & P, rate the bonds involved in Credit Swap Defaults and give companies and banks scores like Aaa or AAA respectively.
Suppose that the CDS Spread for a five-year contract on AIG, with a principal of $10 million, is 300 basis points. This means that the buyer has to pay $300,000 per year, but obtains the rights to sell the bonds at face value of $10 million and once established there is no change in the spread.
The bonds that are sold are at risk for the default, secured only by the ratings, which are calculated bets against the odds that the company will never default. This is one factor as to how the subprime market was consumed and spread, based on company’s ratings rather then actual cash (explanation simplified). AIG, which was the world’s largest insurance company, with an AAA rating, sold their CDS contracts as if they were selling insurance, without the ability to cover the defaults with asset backing. This occurred without any regulations and by using mark to market accounting.
Mark-to-market is an accounting methodology of assigning a value to a position held in a financial instrument based on the current market price for the instrument or similar instruments. For example, the final value of a futures contract that expires in 9 months will not be known until it expires. If it is marked to market, for accounting purposes it is assigned the value that it would currently fetch in the open market. – Wikipedia
The reality is it will take some time for the system to absorb the problems related to the CDO market and volatility may rule the day of trading. This article refers to the liquidity aspect of the crisis, like when companies like AIG file bankruptcy with some cash flow, but not enough to cover their needs. Right now, it is worth noting we have much more of a confidence crisis than a liquidity crisis, and this too is on the world front.
Warren Buffet Speaks; Wit and Wisdom from the World’s Greatest Investor, 1997:Investment must be rational! If it doesn’t make sense and you can’t understand it, don’t do it!
Until next time,