The further a society drifts from the truth, the more it will hate those who speak it. ... In a time of deceit, telling the truth is a revolutionary act. George Orwell

Sunday, September 21, 2008

Financial World War: last ditch attempt at throwing SEC lawyers against CDS nukes fired by hedge funds?

Today's Bloomberg announcement of SEC subpoena and investigation into short and CDS position of hedge funds may indicate the next stage of the battle where the mainstream American financial institutions and their friends in government decided to fire back at their attackers from the hedge fund "enemy" camp. In my "big picture" model, international hedge funds have been heavily shorting the world financial system, both stock and bonds! Put options can be used to implement leveraged short stock positions; Credit Default Swaps (CDS) can be used for the same purpose to implement leveraged short positions in bonds. Previous partial disclosures of some hedge funds indicated that CDS'es can be an order of magnitude (factor of ~10) larger than the underlying bonds. The amount of leverage that is possible with CDS is probably comparable to that of stock options but - at much lower cost! Shorting the financial companies or other distressed corporate bonds is probably much more lucrative than shorting their stocks. That was probably going on since last year: - the stock shorting action was probably a side attack to trigger their downgrades, to "push" the banks over the cliff so to speak, whereas the line of attack and profit taking took place on their bond shorts.

The last Sunday's unsuccessfull derivative trading session that purportedly "ended up in chaos" showed us that there are many players who seemed more interested in seeing CDS'es triggered rather than unwound. That seems to confirm the "big picture". So is the bail-out of AIG that was deemed necessary just after Lehman's collapse. The AIG suddenly running out of cash and getting a 85 billion dollar life saving injection, just a couple of days from having declared 20B$ cash in possession as adequate (they "borrowed" that from their subsidiaries) clearly indicates that something bad happened to them on that Monday: perhaps that sudden 65B$ shortfall was casued by Lehman collapse triggering their bonds' CDS'es, of which AIG was the liable issuer! Suppose they allowed a subsequent colllapse of Merrill, WaMu and Morgan - could each one of them result in further CDS triggers of the same magnitude, of the order of 300B$ - a nuclear pop just a couple of days apart? Potentially more destruction in just one week than during the first 6 months of the property subprime crisis! This is the real financial nuclear weapon of mass destruction, that Buffett was talking about, seen in action!

Prediction:

Hedge fund "pirates" are fighting on the side of the Free Market. The Mother Nature of Economy is on their side, therefore they will most likely win the war (though might lose this particular battle). Free Market has always won all the wars in the past rendering her institutional opponets, the rulers, the presidents, the main street banks, the governments and the upper classes holding bags of worthless paper. Every single time. This time it will end just the same! The market will win again and effortlessly, the bankers will loose big way, eventually.

Stan (of StanInvest)

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