Monday, May 2, 2016

"It's Official: Puerto Rico has DEFAULTED on $422 Million Payment; Banks and Financial Funds Face Calamity!"

"It's Official: Puerto Rico has DEFAULTED on $422 Million Payment;
 Banks and Financial Funds Face Calamity!"
by Newsroom

"The Commonwealth of Puerto Rico has officially DEFAULTED on its sovereign debt payments by missing a $422 Million payment today. This default has now set in-motion, what may be a calamity for the entire world financial industry. While $422 million is not a lot in the grand scheme of things, there are literally TRILLIONS of dollars tied-into that $422 Million, through investment vehicles known as "Derivatives" and Credit Default Swaps (CDS).

What is a 'Credit Derivative'? A credit derivative consists of privately held negotiable bilateral contracts that allow users to manage their exposure to credit risk. Credit derivatives are financial assets like forward contracts, swaps, and options for which the price is driven by the credit risk of economic agents (private investors or governments).

For example, a bank concerned that one of its customers may not be able to repay a loan can protect itself against loss by transferring the credit risk to another party while keeping the loan on its books. The bank achieves this by going to another institution and purchasing a "Credit Default Swap." In return for that other institution agreeing to pay-off if the borrower fails to pay, that other institution charges a fee to the originating bank every month.  Sort of like "insurance."  If the borrower fails to pay, the bank who issued the original loan goes to the other party who issued the CDS and demands payment.

Banks, Hedge Funds, Money Market Funds and other giant financial services companies have made Billions in the CDS industry by charging fees for POTENTIAL credit defaults which never actually took place. However, when a default DOES take place, it can wipe out all the years of profits made by those giant financial services companies.  

Since a CDS is not "insurance" in the legal sense, entities which enter-into CDS contracts are not required to keep certain amounts in "reserve." So most of them spend the money they take-in via CDS fees hoping they will never have to pay out.  In short, it's a form of gambling. It's a risky endeavor, but with billions in profits to be made by charging fees to issue a CDS, the lure of entering into CDS contracts and collecting those fees is such that almost all large financial entities do it.  

Therein lies the problem; when a default happens, financial entities have to pony-up the cash and most of them have long ago spent that cash on other things. Thus, if it comes time to actually pay-off on a CDS contract, the entity which entered-into the contract to "guarantee" payment, may very well be unable to pay! So that entity goes bankrupt.

That leaves the originating bank swinging in the wind for its now "lost" loan. Maybe the bank can absorb it... but maybe it cannot, so it goes Bankrupt. Now, the bank which made the initial (bad) loan, cannot pay its other bills, so its other creditors go to THEIR Credit Default Swaps to collect... and those other firms cannot pay, so THEY go bankrupt and so on. It becomes a vicious spiral of failing financial entities; all because ONE bad debtor- in this case Puerto Rico- defaulted on its debt.

That is precisely what the world financial system faces right now- and there are some very worried people at some very large banks, hedge funds, money market funds, Pension funds and the like, tonight!

It Gets Worse: When CDS have to be paid out, it is called "unwinding." As entity-after-entity seeks to cash-in on its CDS, and as other entity-after-entity cannot pay and goes bankrupt, the ripple-effect starts to impact the ENTIRE financial system. The "unwinding" of CDS take place over many months and in July, guess what happens? Puerto Rico has to make ANOTHER payment, this one almost double, at $700 Million. Since they cannot pay today's $422 Million, does any rational person think they'll be able to pay the $700 Million two months from now? That will start another- even bigger- CDS unwind, involving more financial entities.

It's Mostly Done Privately: Most Credit Default Swaps are privately negotiated contracts. So publicly-traded entities are not necessarily required to reveal to anyone what their potential liability is for the CDS they have issued. How will anyone find out if those entities cannot pay? When they fail to pay or file for Bankruptcy. SURPRISE!

Could this be the "Black Swan Event" that takes down the house of cards which is the worldwide financial system? No one is saying. But any reasonable person, who understands how this "Derivatives" system operates, already knows there are dark storm clouds on the horizon of the financial system. And if it collapses again like it did in 2008, there is no one left to come to the rescue!

Governments are so broke, they cannot bail any of these entities out anymore. Taxpayers, furious that they got put on-the-hook for the 2008 bank bailout, will utterly forbid another bail-out, which leaves the entire financial system hanging by its neck from its own rope. How this will affect us all remains to be seen, but many have a sick feeling "this will not end well." That may be the understatement of all history!”
Coming soon to a bank near you...

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