The financial crisis is not over. If things were back to normal, banks would be lending to each other and to businesses and individuals. But measures of bank lending risk suggest fear is 12 times as high as it would be in normal times. The reason? Banks know more than you do about what's wrong. And they're not talking about it because they don't want you to withdraw your deposits and sell your stock. What they know is that on October 21st, some of the biggest players on Wall Street could be required to come up with $400 billion that some may not be able to pay.
Last month, the White House decided that we could afford to let Lehman Brothers file for bankruptcy. That proved to be an enormous mistake. It triggered a run on money market funds because one of the oldest such funds, Reserve Primary, broke the buck since it held Lehman Brothers paper. The U.S. responded with a $50 billion guarantee of money market funds. But the biggest consequence of that mistake is in the $54.6 trillion market for Credit Default Swaps (CDSs).
A CDS is like selling insurance on your car to hundreds of people who don't own it -- yet if your car goes up in flames each of those people collects the full value of your car. More specifically, CDSs are insurance against a bond or loan default. Why are CDSs so dangerous? Three reasons: a CDS seller does not need to put any capital aside to cover losses if the security defaults, the buyer doesn't need to own the asset it wants to protect, and there is no central place where information about all these CDS deals is collected and updated.
Surely our biggest financial institutions would shun such risky contracts, right? Wrong. Thanks to $16 billion in CDS insurance premiums over the last two years, three of the largest banks on Wall Street -- JPMorgan Chase (NYSE: JPM), Citigroup Inc. (NYSE: C) and Bank of America (NYSE: BAC) -- control 92% of the CDS market. For years, those CDS premiums were almost pure profit. But the financial crisis has changed all that.
Imagine that 100 firms had accepted a CDS contract to guarantee payment on a $1 billion bond and then the bond issuer entered bankruptcy and stopped making payments. That would mean that the recipients of those CDS premiums would need to pay up. Following the burning car analogy, the CDS policyholder would get $100 billion (while oversimplified, this example calculates the $100 billion figure by multiplying the 100 insurers by the $1 billion bond amount). But the CDS market does not require those 100 firms to hold any capital in reserve in case they have to pay off their bet. And if they don't have the money to fulfill their obligations, one option is a bankruptcy filing.
This comes to mind in considering how Lehman's bankruptcy could spur a system wide collapse. On October 21st, the settlement of Lehman CDSs will be announced and it could involve payments of between $100 billion and $400 billion. One of the biggest payers will be American International Group (NYSE: AIG) which is now famous for taking $122.8 billion of our money and enjoying plush retreats.
But there are others -- such as hedge funds and investment banks -- which are also likely to be on the hook. Fear of what will happen on October 21st is keeping the credit markets frozen.
If you're wondering how this situation ever arose in the first place, you don't have to look all that far. In 2000, John McCain's chief economic advisor, Phil "Americans are Whiners" Gramm, deregulated the CDS market.
Don't forget to vote on November 4th.
Peter Cohan is President of Peter S. Cohan & Associates. He also teaches management at Babson College and edits The Cohan Letter. He owns AIG and Citi securities and has no financial interest in the other securities mentioned.