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Paul A Drockton M.A.
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China, AIG and the Derivatives Market
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Musings of a Dead Man
Paul A Drockton M.A.

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Paul A Drockton M.A.
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Bonds are long-term debt instruments. They can be issued by Governments, Corporations or even Individuals. Federal Government bonds are considered the most secure because they are "insured" or backed by the "Good Faith and Credit" of the United States Government. Municipal (State and Local Government) bonds are next. Then come Corporate Bonds. Almost all bonds that are sold to the public are rated by Bond Rating companies like Moody's Investment Service, which measures the issuing entity's ability to repay the loan. No collateral is bad. Income as collateral is better. Real-Estate or some other appreciating asset was best.

Enter the subprime mortgage. This is a risk that would be bad on anyone's books. Poor payment history, poor or no income history, poor credit history or a lack thereof. The only thing that made a subprime mortgage attractive to investors was the fact that they could foreclose on the property in a real-estate market that was going nowhere but up.

When the Fed raised interest rates and slowed down the housing market things got a little dicey, but the process continued in spite of the increased risk. The primary reason was so-called "Credit Default swaps"

"Credit default swaps are insurance-like contracts that insulate a customer against the chances that the debt obligations they cover might not be paid. The unit typically sold the swaps to big institutional investors that issued or held collateralized debt obligations. Many C.D.O.'s were backed by mortgages. Through its swaps, A.I.G. guaranteed some $440 billion in obligations."   (Source)

In layman's terms, the credit default swap insured the big investor against loss from default. Since they were primarily used in corporate and residential real-estate investments that were not insurable in a standard sense (under Fannie Mae, FHA or Freddie Mac) they basically took an unacceptable risk and turned into insanity. Placing a entire corporation's assets at risk, like AIG did, in a volatile "high-risk" environment would normally be grounds for malfeasance or worst.

"In the late 1990s, under Cassano, A.I.G. Financial Products ramped up its business of selling credit default swaps, which are insurance-like contracts for big investors with debt obligations—and which lie at the heart of its recent woes. Its main clients were European banks.

"The nature of the program changed," said a person close to Greenberg, adding that over six months in mid-2005, A.I.G. Financial Products expanded dramatically into writing swaps to cover debt that was backed by mortgages."

In other words, as the market became riskier, AIG bought itself more exposure. An insurance company that knows when you will die and how to make money off of that knowledge, would never underwrite a cancerous 90 year old male on life support. Yet, that is exactly what they did, placing the entire company, its employees and its faithful policyholders at risk of losing everything through its insolvency.

The Government bailout of AIG  has nothing to do with the average American and everything to do with saving the ass(ets) of these big institutional investors. It is now to the point where it truly has become a matter of "National Security".

Enter China:

"In July 2009, China held $800 billion of U.S. Treasury securities, up from $550 billion in July 2008, according to the Treasury Department. China, which has surpassed Japan as the largest foreign holder of U.S. Treasuries, accounts for 23 percent of total foreign holdings. In a period in which the U.S. Treasury is flooding the market with new supply—thanks to the massive deficits we're running—China is a leading export destination. The same holds true, albeit to a lesser degree, for debt issued by quasi-government agencies such as Fannie Mae and Freddie Mac. (Market analysts fretted in August when it was revealed that China had sold a net $4.6 billion of so-called agency debt in the previous month.)"

Big investors do make big political donations, but that doesn't explain the whole story. By bailing out AIG with newly printed Federal Reserve Notes, the administrations of Bush and Obama have basically transferred worthless risk that should never have been taken into the hands of the American taxpayer.

If you don't understand this, allow me to explain. Your next door neighbor decides he has a legitimate chance at buying the "Brooklyn Bridge". He thinks it might be a little too risky, so he gets AIG to write an insurance policy that will cover his investment. Real Estate prices collapse and the Brooklyn Bridge is now worth 10 cents on the dollar. To make matters worse, no one wants to rent the property and now it has zero income. Because of the "Credit Swap", AIG is screwed.

To make matters worse, a Chinese investment company owned by the Chinese Republican Guard got suckered into buying a 50% interest in said investment. Now, not only do we have a domestic problem, we have an international incident...

"Several Chinese companies, including some with ties to the government, have taken big losses on derivatives and hedging contracts. CITIC Pacific, which is owned by a state enterprise, last year said it could face loses of up to $2 billion on foreign exchange investments. Airlines like China Eastern and Shanghai Air have similarly taken a bath on jet fuel hedges gone sour." (Ibid)

Can you say, "I've been sclewed!" in Chinese? I'll bet you can! But, then again, 2 billion is chump change...

"But it's no longer just the Chinese central bank buying government debt. Now entities controlled by the Chinese government are buying stakes in American financial intermediaries. China Investment Corp., the sovereign wealth fund that is sitting on nearly $300 billion in assets, owns 10 percent of the Blackstone Group, the large private equity firm. In June, CIC bought $1.2 billion worth of Morgan Stanley shares, bringing its stake in the chastened investment bank to 9.9 percent. (CIC had spent $5.6 billion on Morgan Stanley shares back in late 2007.)" (Ibid)
To make matters worse...

"in mid-September, Caijing reported that, with SASAC's blessing, several state-owned companies "have sent legal warnings to six international investment banks over derivatives trade losses." Caijing further reported that, "according to incomplete data, 28 central government SOEs were involved in the financial derivatives business in September, and that most had chalked up losses."

This might explain why the Chinese puppet state of North Korea has just renewed its hostilities with the South. Perhaps just another warning to the West on what will happen if the trillions of dollars in derivatives contracts China holds go unpaid. Remember, we're not bailing out AIG.

We're trying to avoid World War III.

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