A default by any other name is still a default. When Greece defaults, the  inter-connected chains of credit default swaps will fall like dominoes.

For your Superbowl half-time reading, here is a brief summary of the situation in Europe:

1. Greece is poised to default, the end-game everyone anticipated in 2011. It is not a matter of if but when.

2. That default will trigger credit-default swap contracts, derivatives known as CDS that protect the owner from events such as default.

3. This will implode the shadow-banking system and the visible banking system, as those who sold the CDS (financial institutions) do not have enough cash or assets to pay the owners of the CDS.

4. The general idea is that sovereign default is very unlikely, so you can sell protection (CDS) against that possibility for a low premium, and cover that bet by buying your own protection from another player.

5. If that player (counterparty) can’t pay you off, then you can’t meet your obligations on the CDS you originated and sold.

6. So the failure of one counterparty can trigger a systemic failure akin to a row of dominoes being toppled by the fall of one domino.

7. To avoid such a CDS-triggered collapse, the European Union and its proxy agencies (European Central Bank, etc.) are attempting to call a default by Greece something other than “default.”

8. This will theoretically keep the first domino–a credit-default swap–from falling.  In other words, if we call a default by some other name, then it isn’t a default.

9.  Those absorbing the losses caused by a Greek default (and let’s stipulate that this references owners of Greek debt who bought CDS as insurance, not speculators who leveraged CDS at 30X the actual bond value) will want to cash in their insurance, i.e.  the CDS they own against a Greek default. They have every incentive to demand a default be  recognized as a default. If they accept the official plan to avoid calling a default a default, then all the losses will be theirs and none will fall to the counterparties who sold them  the CDS.

10. How is this fair?

11. The official response of avoiding default is focused on self-preservation, not fairness, justice or the rule of law.

12. The system can be likened to a pool of $100 bets leveraged off $5 in cash. If every bet is covered perfectly, then it’s somewhat like $95 in bets being paid by passing $5 around–much like the famous email that depicts all debts in a small town being paid by the same $5.

13. In the real world, somebody’s bets and insurance will not be perfect and their obligations will exceed their cash on hand. In other words, they will end up with $3 and owe $5. They will default and the dominoes will start falling as everyone down the line doesn’t receive their $5 counterparty payoff.

14. Empires tend to fall when the interests of their Elites diverge.  We are at such a point in the global financial Empire.

15. “Extend and pretend” has “worked” for almost 2 years. If Greece defaults and it is recognized by even one player as a default, then the system will quickly unravel and cash/dollars will be king until the deleveraging runs its course.

Charles Hugh Smith – Of Two Minds

There’s really not much more to say than this….

Value	1,577.42
Change	593.840 (60.375%)
Open	1,577.42
High	1,577.42
Low	1,577.42

Source: Bloomberg (click link above)

No, that’s not a stock.  It’s the CDS spreads on the PIIGS (composite), and is up an astounding 60% today.

It’s over folks, despite the protests of BNP, which reacted in predictable fashion to a WSJ “opinion piece” this morning:

‘We can no longer borrow dollars. U.S. money-market funds are not lending to us anymore,” a bank executive for BNP Paribas, who declines to be named, told me last week. “Since we don’t have access to dollars anymore, we’re creating a market in euros. This is a first. . . . We hope it will work, otherwise the downward spiral will be hell. We will no longer be trusted at all and no one will lend to us anymore.”

The bank denied it, of course, and the source “declines” to be named.

So what’s the truth?

It’s simple: We’re all Greece.

There’s no material hiring going on in the US, nor will there be.  Not because business wouldn’t like to hire, but because there’s no organic demand with which to require the hiring to take place. As a former CEO I can tell you that hiring is a dispassionate decision: You hire staff to produce the goods or services you sell – and for no other reason.

The Government took upon itself to create false economic demand after 2008 through deficit spending.  Private business knows this cannot continue forever, or you get Greece.  It’s not really very complicated; try using your credit card to maintain a $173,000 lifestyle when you only make $100,000 and see for how long you’re able to do it.  That’s what our Government has sequentially done for three years running from 2008-2011.

Every businessperson with an IQ larger than their shoe size knows that this path forward will – because it mathematically must – fail.  They were willing to accept a short-term incidence of this back in 2008, because that’s exactly what they believed it would be – a very short-term phenomena.

But now, in 2011, it’s clear that it isn’t a short-term phenomena.  And as a consequence there is no hiring going on, because this Ponzi must end, and when it does these businessowners know the outcome will be horrific.  They do not intend to get caught not under the falling knife, but the falling grand piano.

The President and the Republican candidates can claim to have “plans” or want “stimulus” or whatever.  The fact is that none of this will work.  It will not work because the claims of “deleveraging” and “balance sheet repair by consumers and households” is a lie.

Source: Federal Reserve Z1

De-leveraging and balance sheet repair?  Where?  Total consumer and mortgage indebtedness is only back to 2007 levels (when we hit the wall and we had a much-lower unemployment rate.)

The often-repeated claim that balance sheets at the consumer level have been “repaired” is a bald lie, repeated nearly daily in the media, in an outrageous and puerile attempt to goad both consumers and businesses into taking economically unsound steps.

This strategy of lie, lie and then lie some more has failed.

The only actual fix is to truthfully de-lever.  This means not supporting the bankrupt, other than shepherding them through the courthouse door where their bankruptcy proceedings are heard.  It may mean some sort of expedited process for bankruptcy, which I’ve advocated for quite a long while.

We need to remove one half of the total credit market debt in the system in the United States alone.  There are only two ways to do it – default and/or pay it down, or grow fast enough without taking on any more credit that the percentage of GDP represented by debt declines.

The latter is not going to happen because the entire last 30 years of our so-called “growth” was a Ponzi built upon more and more debt everywhere.  Yes, during Clinton, yes, during Bush (pick a Bush), yes, during Reagan.

This is the truth whether you wish to hear it or not.  Whether you wish to face it or not. And until we as a nation and the world as a whole stop playing pyramid games with debt there will be no actual and functional recovery.

We used currencies, offshoring and other means of market manipulation to cover up that which could not work on a sustainable forward basis.  We built the pyramid ever-higher, driving asset prices to the moon, and yet none of these “asset price” gains were real and underpinned by actual returned cash earnings.

The check is on the table folks. Europe was just as profligate as we were, and their banks were just as immature in their “analysis” before buying up debt – that is, lending people money who had no prayer in hell of ever paying it back.

This is the same game that was run in the 1980s, the 1990s with the Internet bubble, and then in the housing bubble in the 2000s.

In the 1990s when I ran MCSNet the claim of “trees grow to the moon” was predicated on the Internet doubling in size every three months.  This was true for about a six month period immediately following the introduction of Windows 95, which was the singular event that brought Internet access to the mass-market.

From that point onward it was a knowing and intentional lie.

Yes, penetration continued to grow and yes, the network continued to expand, but the explosive doubling pattern happened on the original “uptake” and then ended.  It had to, because if it had not every bacterium on the planet would have had internet access within a bit more than a decade.  This, again, is mathematics.

There were literally thousands if not tens of thousands of people who had access to the core routing tables and data flow rates that knew the claims being made were lies, myself among them.  Sure, as the type of data being moved went from plain text (Gopher and embryonic HTTP) to images to sound-and-graphics and then full-motion video the data requirements continued to grow but the fanciful claims of doubling every three months simply couldn’t have gone on for more than a couple of years because the following is what would have happened:

2
4
8
16 < End of first year
32
64
128
256 < End of second year
512
1,024
2,048
4,096 < End of third year (!)
8,192
16,384
32,768
65,536 < End of fourth year (!)
…..
4,294,967,296 < End of eighth year (!!!!!)

Incidentally, that last figure is approximately (within one additional three-month period) the number of people on the planet.

This is the problem with exponential (compound) growth.  It’s inherently a pyramid scheme and inherently must, at some point, end.  It must end because eventually you run out of ability to sustain it – you run out of suckers and the pyramid collapses.

This always happens because it mathematically must happen.

When debt grows faster than output on a compound basis the two curves inevitably run away from one another and must always result in a collapse.

This is not a political issue, it is not a left or right issue, it is a function of simple mathematics.  Those who were IPOing these businesses in the 1990s and who were building and selling houses into the ramp in the 2000s were simply believing that they would unload the bag on you before the leverage pyramid in that particular part of the economy fell over.

That’s all the last thirty years was folks, and now we’re desperately scrambling on a global basis to find just one more sucker.  To obtain just one more hit off the crack pipe.  To stave off death just one more day and draw one more breath.

Can we pull that off/  Maybe, for today.  Maybe, for tomorrow.

But on a forward, sustainable basis?

There the math is clear and so is the answer: NO.

There has been much digital ink spilled on the Foreclosuregate (or if you prefer, Fraudclosuregate) story over the last couple of years, but one thing has been only touched upon lightly – if at all.

That is the underlying “low-level” fraud that is unspoken in many of these actions.

There’s a general principle under the law when one desires to bring a lawsuit – the principle of injury.  That is, you can’t sue me because you think I’m ugly.  You need to show actual economic damage in order to obtain the relief you seek.  There are many examples where civil courts have reached a conclusion that indeed the facts support the case but there’s been no showing of economic harm and thus the plaintiff gets awarded one penny.

There has been an astounding lack of credulity on this matter of economic injury in these foreclosure suits.  In fact, I’ve yet to see a foreclosure complaint that alleges actual economic injury.

Instead, they all allege it’s cousin, lack of payment.

But lack of payment isn’t necessarily economic injury.

Let’s say that you hit me in your car.  You have insurance and so do I.  My medical treatment costs $20,000, and you’re ruled entirely at fault in the collision.  We’ll assume for the moment I have no “pain and suffering” damages nor lost time at work and thus no lost income – that is, we have a neat and tidy case where the total economic harm is $20,000.  I cannot sue you unless my economic injuries are not paid for through some other means.

If your insurance company pays the medical bill, I no longer have economic harm, thus I cannot win anything in a lawsuit.  Likewise if my insurance company covers the bill (unless it jacks up my insurance rates or somehow otherwise damages me.)  Finally, you might just hand me $20,000, which moots my pending lawsuit immediately as once again, I have no economic harm.

When a mortgage loan is packaged into one of these “securities” and then all sorts of protection and credit enhancement are taken against it, it is no longer a simple matter of saying that because you didn’t pay, there are economic damages in the amount of your lack of payment.  In fact, there may be no economic damage sustained by the entity that is suing you at all!

Take the instance of a “credit default swap.”  Remember that a CDS is not an insurance contract.  That is, it typically will not contain things like a right of subrogation or set-aside (the ability to go after the cause(s) of the payment under the CDS contract or pursue other assets of the defaulter in court) but rather is a pure “payment for event” sort of agreement.  Well, if that CDS payment moots the economic damage, does the alleged foreclosing party still have standing to eject you from your house?

Let’s follow this through an MBS.  For simplicity sake we will assume it is comprised of 1,000 loans.  Let us further presume that 10% of those loans default.

Ok, can you foreclose on those homeowners?

Remember, to be able to sue for a remedy in civil court, you must show economic harm.  A breach without economic harm brings no right of recovery!  Being pissed off is not economic harm, and neither is non-payment unless the party suing you, directly or through an agent, suffers a loss.

Well, in the base case you’d probably say “yes”.  But who can sue?  Normally the PSA delegates this authority to the servicer or their agent.  Again, however, the underlying facts to be pled in a lawsuit that permit recovery must demonstrate economic harm.

The key question: Were the certificate holders economically harmed when all of the payment flows are accurately accounted for?

Well, that does depend now, doesn’t it?  The super-senior holders might not be, because of their credit protection.  More-junior holders might be harmed, but then the question turns on an accounting – was there credit protection bundled with the tranche or did they purchase it individually?  Was their position actually damaged as a consequence of your non-payment?

Hmmmm…. looks like we need an accounting here of the trust and the actual economic harm, right?  This does not mean, by the way, that one must show any particular amount of harm, beyond the general threshold of “materiality”, to sustain a foreclosure.

But what if there is no harm at all because of these credit enhancements and swaps, and in fact foreclosure is actually a double-dip – that is, double recovery?

In that case all such foreclosures are fraudulent.  Not because of a lack of paperwork and not because someone “should” or “should not” get a free house – but simply because the entity bringing the suit not only didn’t suffer a loss, they stand to gain rather than recover a loss through doing so.

Can I ask why we don’t see both pleadings where a securitized loan defaults alleging actual economic harm and an accounting of how that’s arrived at, rather than its surrogate – the allegation that you didn’t pay?

The German Government Has Had Enough

Posted by Karl Denninger

If you thought the German government was going to be a lapdog for Sarcozy, or worse, was going to fellate Brussels and the ECB, you got a rude shock today.

It appears that the German Government has just plain had enough of the crap that the banksters have tried to pull, and has decided to do what Barack Obama should have done in early 2009.

That is:

• No more naked credit crap, especially against sovereigns but not only against sovereigns.  No insurable interest, no CDS – period.
• Naked shorting will now be actually stopped in 10 leading financial institutions.
• Germany has had it with naked shorting of Gold, and specifically noted bank manipulation of gold prices via naked shorts beyond intent or ability to deliver.
• Germany has also said that they’re not going to permit Euro derivatives that are not a “bonafide” FX hedge.  That is, no more naked bets on Euro movements either.
• Hedge funds are going to be regulated, position size limits mandated and enforced, reporting enhanced and a transaction tax is coming.

It’s about damn time.

Oh, and it appears that instead of telling all the banksters what they were going to do and “getting permission” first, or even discussing it with other governments, the German Government did what all governments should do – make up your mind and then do it without giving a good damn whether the banksters or other governments like it – and without giving them input into the decision or notice that it’s coming.

The bid rigging, the game-playing and the rest are all a bunch of crap.  I’ve been hollering about this now for more than three years and yet our government spends it’s time fellating the bankers and their dogs instead of enforcing the law.

It is illegal to defraud people.

It is illegal to rig markets, including the massive bid-rigging that I wrote about this morning, the Jefferson County Alabama scam and dozens if not hundreds more – all committed, it is alleged (and in some cases proved) by the major banks.

It is illegal to short stocks with no intention or ability to deliver.

And it is illegal to bribe government officials, no matter how you accomplish it.

These are not “isolated incidents” or even a pattern of conduct – as the bid-rigging report this morning makes clear ripping people off has become an institutionalized practice and policy throughout the entire banking system.

Many said that the Germans were not “really” arm-twisted by Sarcozy and the French Banking interests a week or so back.  I think we can put that to rest here and now, as it’s pretty clear that the truth is something else entirely.

Now Barack, about your willingness to get up off your knees and kick these banksters in the nuts?

Better late than never.

Containment Fails: European CDS Explode As Market Looks To Future Bail Outs, Bank Runs

Submitted by Tyler Durden

Now that Greece is thoroughly irrelevant, the market just told the ECB, the IMF, and the EMU to prepare another $1 trillion in bailout packages. The reason: the Greek bailout just made it abundantly clear the bond vigilantes have free reign to call the bureaucrats’ bluff whenever they see fit. The result: CDS of all non Greek PIIGS are now blowing out, and represent the top 4 names of all biggest CDS wideners for the day, each pushing a 10%+ change from yesterday. This movement wider will not stop until the IMF resolves to backstop all the PIIS ex. G. At this point nothing that happens in Greece is important, although the thing that will most likely happen is that the Greek government will fall imminently, killing the austerity package and destroying whatever credibility the EMU and the EU have left, but not before the IMF and the EU soak up another 110 billion euro in their slush funds. However, even with the bailout the Greek stock market is tumbling: the Athens Stock Exchange is now down 3.4% to just under 1,800. As we expected, the euro is about to breach 1.31 support. At that point, not even the US algos and the Liberty 33 traders will be able to prevent the contagion. And adding insult to injury is the latest rumor of an upcoming downgrade or very cautious language of Germany by the suddenly hyperactive rating agencies. When that occurs, you can kiss Europe goodbye.

Biggest CDS intraday movers (from CMA):

On Our Rotten Financial System

Posted by Karl Denninger

So today Goldman will come before the Senate Permanent Committee on Investigations – with Lloyd himself, along with “Fabulous Fab” on the witness panel.

Blankfein’s prepared testimony makes some interesting claims:

“We didn’t have a massive short against the housing market, and we certainly did not bet against our clients,” Blankfein says in prepared remarks released by the company. “Rather, we believe that we managed our risk as our shareholders and our regulators would expect.”

Uh, Lloyd, are you sure?

Carl Levin, a Michigan Democrat who leads the Senate’s Permanent Subcommittee on Investigations, released documents that he said showed the company “put its own interest and profit ahead of the interests of its clients,” a conflict he called on Congress to end. Lloyd Blankfein, Goldman Sachs’s chairman and chief executive officer, will dispute that assertion and argue the firm was merely managing its own risk.

Yep. 

It’s amusing how Goldman claims it “lost money” on some of these deals.

So what?

The question is not whether there were residual pieces of trash that Goldman wound up (unwillingly) eating when they couldn’t sell them.  The question is whether or not Goldman (and everyone else) should have had the ability to put these deals together in the first place, and how it came to be that trillions of dollars of alleged “AAA” paper was better suited for use in the men’s bathroom stalls!

Levin said:

“This market is not free until it is free of self-dealing and until it is free of conflict of interest,” Levin, 75, said at a press briefing yesterday. “It is not free until it ends the gambling operation that results in gambling debts that the public ends up paying.”

That can’t happen until we see handcuffs Senator. 

“The SEC and the courts will resolve the legal question of whether Goldman’s actions broke the law,” Levin said. “The question for us is whether Goldman’s actions in 2007 were appropriate and whether we should act, legislatively, to bar similar actions in the future.”

17 pages Senator.  They’re called “Glass Steagall”, and that law absolutely barred the conduct that led to and caused this crisis.

Let’s be frank: Creating these sorts of toxic deals is, for these institutions, simply a reach for fees.  They don’t care if they perform so long as they don’t get stuck with the trash.  A particular transaction was even referenced as “one shi&&y deal” by Goldman employees, according to some internal emails:

“Boy that timberwo[l]f was one shi**y deal,” Montag, who is now Bank of America Corp.’s president of global banking and markets, said in a June 22, 2007, e-mail to Daniel Sparks, who ran Goldman Sachs’s mortgage business at the time, according to the panel’s statement. Within five months of Timberwolf’s debut, the CDO had lost 80 percent of its value, and it was liquidated in 2008, according to the panel.

The CDO was among securities that Goldman Sachs sold to clients after deciding the New York-based firm needed to reduce its mortgage holdings, Carl Levin, a Michigan Democrat who leads the panel, said in the statement. Chief Executive Officer Lloyd Blankfein and six other current and former executives will testify tomorrow in front of the panel about practices in mortgage securities markets before they collapsed.

And of course such conduct, and the people who commit it, aren’t fired.  Mr. Montag is now Bank of America’s president of Global Banking and Markets.  “Market discipline” doesn’t, it appears, extend to forcing people to eat their own cooking and when they sell things they know smell like dead fish to clients, it’s all ok.

Perhaps it is under the law, but whether it should be is another matter.

It is often argued that if we don’t permit this sort of “innovation” that our economy and businesses will suffer.  Really?  Who suffers?  Wall Street?  Can we reasonably have an economy where 1/3rd of all profits made in the nation are “earned” by asset-stripping other people?  That’s what even the good deals do – they turn over a part of the transactional flow of some business to the wall street banks, which then keep it for themselves. 

The bad deals, like this one referenced, are even worse in that they siphon off fees from someone who later loses all their money!

This is not restricted to Goldman, by the way.  Indeed, let’s examine another deal that the government was intimately involved in, this first reported by Zerohedge in the form of the Fannie Mae Preferred offering that was foisted on the market just weeks before the firm blew up.

The underwriters, who coincidentally received 3.15% of $2 billion, or $63 million bucks, include Merrill Lynch (now absorbed), Citibank (rescued), Morgan Stanley, UBS (who has a running spat with the IRS about assisting Americans in illegally evading taxes) and Wachovia (which collapsed in a ball of fire that was contained only by forced marriage to Wells Fargo.) 

Why was this deal so insanely toxic?  It was issued on May 19th of 2008, and paid exactly one coupon before Fannie was absorbed into conservatorship. 

And unlike the “sophisticated investors” who bought CDOs and other similar trash from the big banks, this deal was bought by literal widows and orphans, along with community banks.

I would argue that it should have never been brought to the market in the first place, as before it was offered I had opined (in public in fact) that Fannie and Freddie were both insolvent.

Indeed, on March 8th of 2008 I called out the games in a letter written to President Bush and others in which I said (among other things):

Mr. Bernanke and The Fed have lowered the Fed Funds Target from 5.25% to 3% over the last few months and the “slosh”, or free funds available in the Fed Banking System, has nearly doubled over that time. Yet this additional liquidity has done nothing to address the problem and won’t because the issue is not one of inadequate liquidity; rather it is a desperate move to hide the fact that a significant number of financial institutions in our nation are, if forced to mark all their paper to the market and recognize their exposure to off balance sheet vehicles, insolvent.

At the root of the matter, Mr. President, is a lack of trust caused by the intentional acts of these institutions, and lack of regulatory enforcement by both the Federal Reserve and other agencies such as the OTS and OCC.

We have fixed exactly nothing since then.  We have only papered over the insolvencies with government fiat currency, claiming they’re “loans” – and they are in a sense – they’re forced purchases of bankrupt companies by the taxpayer which we are now liable for.

Wall Street created this monster with the full knowledge and permission of the government. 

Despite laws prohibiting executives from signing off on fraudulent financial statements – that is, any financial statement that does not make a full and fair exposition of the firm’s financial position (Sarbanes-Oxley) these executives have not been prosecuted.  “I didn’t know” is not a defense under Sarbox – if you’re in the executive suite of a public firm you have an affirmative duty to know. 

So why have not the former CEOs of Bear Stearns and Lehman been indicted?  Why have not the CEOs of the other big banks that failed, all of whom proclaimed that everything was fine right up until they blew sky high? 

As for all these hinky deals that the big banks did, if this crisis has taught us one thing it is that if there’s a way to game a rule or regulation it will be gamed.  So long as these firms can find a way to play “heads we win, tails taxpayers lose” they will do so.  So long as they can effectively force companies to forfeit 30% of every dollar of GDP produced in this nation to them, they will do so.

So long as firms with access to federal assistance of any sort, whether it be The Fed window, overnight repo loans from or by firms with Fed Clearing access, or the privilege of deposit-taking and fractional loan-making exists, these firms will leverage government-provided backstops to their own benefit for the purpose of fee extraction. 

These fees do not benefit society as a whole.  They are in fact a tax on top of all other taxes that firms and thus individuals pay.  This burden is, today, roughly 30% of GDP, and our nation and its economy simply cannot afford to redirect this vast amount of wealth to a handful of rich and powerful people on Wall Street, whether their acts are founded in illegal conduct or not.

17 pages Senator.  That’s all it takes.

Reinstate Glass-Steagall and force all these banks to spin off the parts of their organizations that are in conflict.  All institutions that want access to any sort of public safety net, whether it be Fed Discount loans or FDIC insurance may not trade in or on the securities and insurance markets – OTC or otherwise – period.

Force all instruments onto a public exchange, including all CDS, without exception.  This immediately forces nightly margin supervision which prevents the sort of detonations that happened with AIG and others, and absolutely bars contagion, as no firm can maintain a position that it cannot back with capital.

It is often said that if we do this firms will “flee” to other nations that don’t have such restrictions.  No they won’t – not if we refuse to grant them access to our securities markets and the firms in them unless they comport with these rules worldwide no matter where they are headquartered. 

America is a vast economy.  Yes, China is growing, but we’re still a plurality of world GDP. 

Firms will threaten Senator, but if the law is crafted such that if they want access to our markets in any form or fashion they must comply worldwide with separation of function and exchange clearing, they will comply.

Yes, they’ll make “less money”, and that’s their argument against such changes. 

But let’s be frank – every dollar Wall Street “makes” it in fact extracts.  That is, Wall Street creates nothing.  It siphons off capital from other production – that’s all it can do, since it creates not one car, television, or cellular phone.  Indeed, every dollar of fees extracted by Wall Street and every dollar of interest paid to those firms is one dollar that cannot be returned to the economy in the form of innovation for the production of goods and services.

The essential functions of clearing payments and matching those who wish to loan capital with those who wish to borrow it is ministerial.  All the hinky deals alleged to “spread risk” have now been proved to do no such thing, but instead are complex simply so as to be difficult to understand and thus easy to intentionally misprice. 

That mispricing is fraud Senator, whether it can be legally labeled as such or not, and until we put a stop to it we will continue to have these bouts of crisis, each worse than the last.

Our government and society cannot withstand another banking system attack run, and it is imperative that The Senate, along with prosecutors, put a stop to it both through legislation and prosecution.

We have one last chance to stop it.  If we do not at this time do so, and another ”market failure” occurs, our economy and even our political system – that is, our society and republican form of government – will fall.

Those are the stakes, and the question before you now is whether the bribery that is rampant in Washington (although we call it “lobbying”) will win, or whether you will rise to the occasion and uphold the oath of office that you, along with every other member of Congress, took before being seated.

Dimon Fumbles For His Protective Plate

Posted by Karl Denninger

IRA Does It Again (See, Again I Told You So)

Posted by Karl Denninger

Oh, The Off-Balance Sheet Lies Are International?

Posted by Karl Denninger

By Gretchen Morgenson

AS more details surface about how derivatives helped Greece and perhaps other countries mask their debt loads, let’s not forget that the wonders of these complex products aren’t on display only overseas. Across our very own country, municipalities, school districts, sewer systems and other tax-exempt debt issuers are ensnared in the derivatives mess.

Like the credit default swaps that hid Greece’s obligations, the instruments weighing on our municipalities were brought to us by the creative minds of Wall Street. The rocket scientists crafting the products got backup from swap advisers, a group of conflicted promoters who consulted municipalities and other issuers. Both of these camps peddled swaps as a way for tax-exempt debt issuers to reduce their financing costs.

Now, however, the promised benefits of these swaps have mutated into enormous, and sometimes smothering, expenses. Making matters worse, issuers who want out of the arrangements — swap contracts typically run for 30 years — must pay up in order to escape.

That’s right. Issuers are essentially paying twice for flawed deals that bestowed great riches on the bankers and advisers who sold them. Taxpayers should be outraged, but to be angry you have to be informed — and few taxpayers may even know that the complicated arrangements exist.

Here’s how municipal swaps worked (in theory): Say an issuer needed to raise money and prevailing rates for fixed-rate debt were 5 percent. A swap allowed issuers to reduce the interest rate they paid on their debt to, say, 4.5 percent, while still paying what was effectively a fixed rate.

Nothing wrong with that, right?

Sales presentations for these instruments, no surprise, accentuated the positives in them. “Derivative products are unique in the history of financial innovation,” gushed a pitch from Citigroup in November 2007 about a deal entered into by the Florida Keys Aqueduct Authority. Another selling point: “Swaps have become widely accepted by the rating agencies as an appropriate financial tool.” And, the presentation said, they can be easily unwound (for a fee, of course).

But these arrangements were riddled with risks, as issuers are finding out. The swaps were structured to generate a stream of income to the issuer — like your hometown — that was tethered to a variable interest rate. Variable rates can rise or fall wildly if economic circumstances change. Banks that executed the swaps received fixed payments from the issuers.

The contracts, however, assumed that economic and financial circumstances would be relatively stable and that interest rates used in the deals would stay in a narrow range. The exact opposite occurred: the financial system went into a tailspin two years ago, and rates plummeted. The auction-rate securities market, used by issuers to set their interest payments to bondholders, froze up. As a result, these rates rose.

For municipalities, that meant they were stuck with contracts that forced them to pay out a much higher interest rate than they were receiving in return. Sure, the rate plunge was unforeseen, but it was not an impossibility. And the impact of such a possible decline was rarely highlighted in sales presentations, municipal experts say.

Another aspect to these swaps’ designs made them especially ill-suited for municipal issuers. Almost all tax-exempt debt is structured so that after 10 years, it can be called or retired by the city, school district or highway authority that floated it. But by locking in the swap for 30 years, the municipality or school district is essentially giving up the option to call its debt and issue lower-cost bonds, without penalty, if interest rates have declined.

Imagine a homeowner who has a mortgage allowing her to refinance without a penalty if interest rates drop, as many do. Then she inexplicably agrees to give up that opportunity and not be compensated for doing so. Well, some towns did exactly that when they signed derivatives contracts that locked them in for 30 years.

Then there are the counterparty risks associated with municipal swaps. If the banks in the midst of these deals falter, the municipality is at peril, because getting out of a contract with a failed bank is also costly. For example, closing out swaps in which Lehman Brothers was the counterparty cost various New York State debt issuers $12 million, according to state filings.

Termination fees also kick in when a municipal issuer wants out of its swap agreement. They can be significant.

New York State provides a good example. An Oct. 30, 2009, filing describing its swaps shows that for the most recent fiscal year, April 2008 to March 2009, the state paid $103 million to terminate roughly $2 billion worth of swaps — more than a quarter of which resulted from the Lehman bankruptcy in September 2008.

(You can find this report online at bit.ly/cS8ZFV.)

As of Nov. 30, 2009, New York had $3.74 billion worth of swaps outstanding. Even so, New York doesn’t have as much of a problem with swaps as other jurisdictions. Still, New York could have spent that $103 million on many other things that the state needs.

The prime example, of course, of a swap-imperiled issuer is Jefferson County, Ala. Its swaps were supposed to lower the county’s costs, but instead they wound up increasing its indebtedness. Groaning under a $3 billion debt load, the county is facing the possibility of bankruptcy.

Critics of swaps hope that increased taxpayer awareness of these souring deals will force municipalities to think twice. “When municipalities enter into these swaps they end up paying more and receiving much less,” said Andy Kalotay, an expert in fixed income.

Why is that? One reason, Mr. Kalotay said, is the use of swap advisers.

“The basic problem is the swap adviser gets paid only if there is a transaction — an unbelievable conflict of interest,” he said. “It’s the adviser who is supposed to protect you, but the swap adviser has a vested interest in seeing something happen.”

WHAT is especially maddening to many in the municipal securities market is that issuers are now relying on the same investment banks that put them into swaps-embedded debt to restructure their obligations. According to those who travel this world, issuers are afraid to upset their relationships with their bankers and are not holding them accountable for placing them in these costly trades.

“We need transparency where Wall Street discloses not only the risks but also calculates the potential costs associated with those risks,” said Joseph Fichera, chief executive at Saber Partners, an advisory firm. “If you just ask issuers to disclose, even in a footnote, the maximum possible loss or gain from the swap they probably wouldn’t do it. And if they did that, then investors and taxpayers would know what the risks are, in plain English.”

Mr. Fichera is right. At this intersection of two huge and extremely opaque arenas — the municipal debt market and derivatives trading — sunlight is sorely needed.