In the opinion of FFP Wealth Management, the recent run up in the market runs contrary to the current financial condition of the world.  We believe that the stock market is due for a significant correction.  As a result, FFP continues to hold onto cash in client accounts while the markets assess the real risk of the European Crisis.
November 17^th was a day of news that recently shook my confidence in the markets. Early in the morning I turned on Bloomberg Radio while on the way to the airport.  I immediately identified a tense tone in the voices of hosts Ken Prewitt and Tom Keene as they discussed the issue that credit default swaps will not pay claims if a country takes a voluntary write-down on their sovereign debt. 

What is a credit default swap and what does the voluntary write-down mean?  Here is my opinion of this action.

A credit default swap is an insurance policy issued to an institutional investor that will pay a claim if the issuer of debt defaults.  Why isn’t this called insurance?  Insurance requires the insurance company set aside cash reserves to cover the risk of loss.  By simply changing the name of the product from insurance to swap the insurance company does not have to reserve cash to cover a loss. 

The value of the CDS rises and falls in sync with the confidence in the creditworthiness of the issuer.  The initial purchaser of a CDS could sell the derivative on the secondary market.  Banks, insurance companies, pensions and hedge funds all invest heavily in the secondary CDS market with their values included on the company’s balance sheet.

The story on Bloomberg Radio indicated that the CDS will not pay a claim in the event of a voluntary write-down.  This is similar to the terms of a life insurance policy that will not pay a claim due to suicide. 

So, if banks, insurance companies, pensions and hedge funds all invest heavily in the CDS markets; and then discover the default will not pay a claim in the current environment of voluntary write-downs; what happens to the value of the CDS?  What happens to the balance sheet of these institutions?  Could this be leading up to a similar impact from the discovery in 2008 that collateralized debt obligations (CDO) were largely worthless? 

Adding to the uncertainty was the fact that Germany’s bond offering of November 23^rd did not sell out.  This was quite unnerving as Germany is the strongest county in the Eurozone.  Two other Eurozone countries have since failed to sell out.  Does this mean that investors have less interest in sovereign debt if the CDS might not pay? How will countries pay the obligations if bond sales fall short?

Since this revelation, the Federal Reserve Bank announced new stress tests on banks and issued a proclamation that banks cannot raise dividends to stockholders or buyback stock unless the test show the bank can survive in an economy with a 9% decline in output and 13.9% unemployment, according to Bloomberg Radio. 

Bloomberg also reported that the cash reserve requirements of banks was reduced by 50% to provide liquidity in the event of a “run on the banks, from any source” was announced in a coordinated announcement from the Federal Reserve Bank and the Central Banks of Europe on Monday, November 28.  To FFP, this implies very difficult economic conditions are looming.   Rather than to hold the now declared excess cash in reserves, it seems that the banks moved all this money to the markets creating a huge stock market rally that does not make sense as the European Crisis expands.  If the cash reserves were liquidated for market investing, where will the banks get the cash in the event of a run now?

Read more about the European Debt Insurance here:

http://www.morssglobalfinance.com/what-has-really-happened-to-euro-debt-insurance/

http://www.pionline.com/article/20111128/PRINTSUB/311289987/