It was the 'Oracle of Omaha', Warren Buffett who famously described derivatives - like speculative Credit Default Swaps (CDSs) - as "financial weapons of mass destruction" in his 2002 annual report to Berkshire Hathaway's shareholders.
And they don't call him the 'Oracle' for nothing... Six years later, CDSs were a little talked-about, yet key reason for the global scale and massive destruction of the financial crisis that started in 2008.
In the current Eurozone crisis, a Bloomberg-Businessweek article aptly titled, "Credit Default Swap Risk Bomb Is Wired to Explode" lays out the reasons how CDSs have helped transform the problems that began with a few banks in Greece into an apocalyptic worldwide crisis.
In theory, CDSs function like insurance contracts on bonds. In the event of a default, the seller of the CDS promises to pay the the bond’s value to the buyer. CDSs are touted as 'risk-sharing' instruments meant to mitigate the impact of a potential default - but in the real world, CDSs seem to ecalate risk of institutional failure into risk of systemic failure!
In essence, CDSs are "financial suicide vests" that can 'take out' the CDS seller - and if that bank has bought a CDS - a chain-reaction (or contagion) is triggered, which can rip apart the financial system and bring down entire economies. This is the reason why the ECB, IMF and Fed cannot let Greece default!
On 7 Dec 2011, India got it's shiny new "financial suicide vest".
Reuters reported that "India's fledgling credit default swap market kicked-off [...] with two deals covering 100 million rupees worth of bonds." It involved ICICI Bank and IDBI Bank.
On 13 Dec, Firstpost quoted a Bloomberg report as saying that costs to protect bonds of Indian banks against default are rising at the fastest pace among Asian lenders: Five year CDS of ICICI Bank jumped the highest to 471 basis points, and swaps of SBI hit a two-year high of 397 basis points.
But India's bankers are bullish over CDSs! CRISIL says that it "believes that the RBI guidelines incorporate learnings from the CDS markets worldwide. Systemic safety and stability remain the regulator’s priority..."
True. The RBI make the rules, but banks and CCIL (Clearing Corp India) which processes the transactions have to uphold them. And CCIL is 83 percent-owned by banks and financial institutions - with the usual suspects: SBI, ICICI, IDBI, LIC, Bank of Baroda and HDFC Bank as its promoters!
Nothing to worry, then... Except...
The launch of India's CDS market was "sooner than expected". Could it be because India's banks are facing increasing "risk of credit default" considering the health of the overall Indian economy?
- India's Index of Industrial Production (IIP) for October (Year-on-Year) had nosedived to -5.1% from +3.5% in the April-October period. Not only has India's industrial output fallen like a rock, it's now sits at the lowest since the height of the previous crisis in Q1 200.)
- The Indian rupee has fallen over 15% to hit an all-time low against the US Dollar - and it is still falling in value! This means that all of India's payments denominated in USD - including its trade deficit and volume of external debt - has grown proportionately.
- Sector after sector (public and private) - including Aviation, Real Estate, Textile, Power Distribuition, and even State Governments - are facing mountains of debts that they cannot pay.
- During the 2008 crisis, India's foreign exchange reserves was 38% MORE than its external debt. Today, it is 0.4% LESS that the external debt.
I am no economist, but here is what I think: CDSs have given India's bankers a "self-destruct button." If they go down, the entire economy goes down with them!
At the very least, the Government of India (a.k.a the taxpayer) now has to bailout every bankrupt company to save its insolvent banker.
But it could get much worse... India's oligarchs, bankers, (IMF-appointed) politicans and (Wall St-appointed) media cronies could push India's economic system to the very edge of a cliff, India's sovereign credit rating will go down a notch - to 'JUNK' status.
"We urgently need foreign exchange," will be the mantra chanted repeatedly in the media. Dr Manmohan Singh's Cabinet will come up with a magical 'rescue package'. It will involve wholesale privatisation of public utilities, PSUs (public sector units), and natural resources. It will also involve across-the-board deregulation in all sectors.
I don't know if he'll have the gall to do it, but: MANMOHAN SINGH MAY 'BE FORCED TO' SELL INDIA'S GOLD RESERVES... AGAIN!
And after we lose our sovereignty, comes the REALLY painful part... Large scale unemployment. Civil unrest. Fractures along India's many cultural faultlines.
Well, have a Happy New Year everyone.
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