This article continues the discussion on the current financial turmoil. This is part of my series "What Caused Home Mortgage Products To Go Out of Control?"

By now, we have all heard about CDOs (collateralized debt obligations), and probably the insurance on CDOs, the so-called CDSs (credit default swap). The CDS is an instrument used to transfer the credit risk of the underlying CDO between two parties (financial institutions).

The CDS is basically a bet between two parties on whether or not a company or a product will default. It is a third party speculation on the outcome of the CDO. The original design is no more than insurance to cover a financial fixed income product in case of its default. Then, if anything changes, such as a company declaring bankruptcy or a debt being downgraded, it will trigger a claim.

Currently, the outstanding notional amount of all credit default swaps is about $45 trillion, more than half of the entire asset base of the global banking system. A natural question is why financial institutions are so interested in them? Why have they created so many of them to make this market so big -- and out of control?

There are many incentives, some of them are larger, some smaller. I will discuss the three major reasons:

I. First, credit default swaps are not normal insurance policies, each side can trade them to make a quick profit (spread) if there is a willing counterparty. Commonly after the original CDS contract is engaged, each side of the original two parties will try to engage another party to further hedge their bet and earn a small spread, pretty soon there are layers of layers of counterparties involved, with total notional amount increasing several folds, and no one knows who they are really dealing with anymore.

You can't monitor this risk since you don't know who your offset bettor down the CDS chain is, and whether he is able to pay even if you win. If you throw the counterparty risk out of the window, you can always find a sucker to do the trade with you and earn a small spread.

This kind of entanglement has never been seen before in the usually highly regulated insurance industry. This is why they are traded in OTC (over the counter) derivative markets which bypasses all government regulations.

This entanglement creates a chain reaction if something happens, even a downgrade, not a default, the claim will trigger a domino effect of many claims cascading down the chain to various parties, and the break of the weakest joint (party), probably a highly leveraged hedge fund, will ripple through all multiple parties involved and likely break the whole chain. It amplifies counterparty risk to the hilt beyond the default risk of the CDO itself.

Let us use the analogy of car insurance, of a type never before heard of: Car insurance company A trades our car insurance policy costing us $1000 per year (or $1,000 revenue for them) with another $1,100 similar policy from another company B to pocket a $100 quick profit. Or we trade our $1,000 policy (company A) with $900 policy from another company C. If we find cheap auto insurance, we just simply cut A out and make a switch to C. Our relationship with insurance company is always one on one.

However, imagine what will happen if both parties can trade the policy with a 3rd party. If an accident occurs, company A would not want to pay us since we engaged company C, and company C would not want to pay either since it was not the original policy. And if company A pays us eventually, they will have to file a claim against company B who will most likely deny such claim.

This is what happened to insurance company AON in a story that surfaced last year from a lawsuit. In this real story, Bear Stearns loaned $10M to an entity in Philippines, to hedge this default risk, Bear then purchased a protection contract from AON for $0.4M. Again to hedge this risk, AON purchased protection from Societe Generale for $0.3M. AON thought they were geniuses, offsetting the risk and at the same time earning an easy quick $0.1M profit. Who says there is no free lunch at Wall St.? Think again!

Then, you guessed it, the loan went bust as expected, Bear sued AON for $10M based on the 1st CDS contract, AON lost the case and paid. Of course, AON then went on to sue Societe. Unfortunately due to some legal technicalities, this time a different court and judge had different opinion.

The judgment this time is that the 1st CDS contract and 2nd CDS contract are two separate contracts, the language is slightly different too, so legally, the resolution of 1st CDS doesn't automatically grant the similar conclusion to the 2nd CDS. Thus, the 1st judgment can't be used and referenced for the 2nd lawsuit, as a result, the risk can't be assumed to automatically be transferred and offset each time.

AON lost the case, and the $0.1M "profit" turns into $10M loss in principal. It is an expensive lunch. This sets an important legal precedence for future CDS lawsuits. A small single $10M default loan from Philippines can impact three parties in this case. Maybe this is one of the unexpected downside of globalization?

Another example. The market cap of GM is only about $11B. However, based on estimates in the CDS market, there are about $1 trillion in CDSs betting on GM and their bonds. Any change in GM's situation, will create a rippling effect in this $1T CDS community of GM.

There are obviously not $1T of GM properties to act as collateral, so you have to trust all parties involved in this wild casino betting that they won't go under water. As a matter of fact, you better pray, because if one goes under, which is a high probability event, it throws a monkey wrench in the whole community, as everyone is trying to rewind and get out at the same time. It becomes a "no way out situation".

Bill Gross at PIMCO did a simple calculation in January at his famous article "Pyramid Crumbling". The total amount of CDS contracts is at $45 trillion. The historical default rate is 1.25%, or $500B CDS contracts will be in default. Assuming a recovery rate of 50%, the resulting loss is $250B alone.

I feel his assumptions are too optimistic. The assumed default rate is far too low if you consider the composition of underlying CDO products with many of them being subprime mortgages, which is unprecedented in the financial history. His recovery rate assumption is probably also far too high if you consider the long process of home foreclosure in a deteriorating real estate market with no buyers and legal tricks which can be implemented by homeowners (refer to my early articles on foreclosure). I won't be surprised to see the real loss to double his estimate to be $500B total.

II. Secondly and more importantly, besides the quick profit by earning a small spread, there is a big incentive to use credit default swaps to smooth earnings from quarter to quarter and hide any losses.

If a CDO is rated AAA by rating agency, almost as good as US Treasuries, why would Wall St. want to buy insurance for protection? At the same time, let us say a AAA CDO enjoys a 50 basis point spread from US Treasury, it is almost as good as free lunch, why would Wall St firms want to eat into the 50 bp spread (and their profit) to buy CDS insurance?

The answer lies in the different account treatments. Wall St firms are not stupid, and they are smart enough to know that their CDOs are not US Treasuries, even if their structured product groups and sales people claim they are, with the backing of rating agencies. It is similar to the promotion of internet stocks in late 1990s, when Wall St. put a "strong buy" rating on a supposedly great internet company with an unbelievable growth story, their internal memo referred them as "a piece of garbage".

Due to GAAP (generally accepted accounting principles) requirement, they need to mark their CDO products to the market if without CDS insurance. This creates a problem for them, since both interest rate and credit spread fluctuate all the time to make them harder to massage their earnings. What happens if people suddenly find out and realize they are really a piece of garbage? They don't want any earning volatility and surprises, especially at the time when their bonus is at stake, even only paper losses for the firm but real money losses for individuals.

However, by purchasing CDS insurance, according to insurance regulations there is no need to mark-to-market anymore, firms need to declare losses only if the CDO is permanently damaged and a claim will have to be paid. No more quarter to quarter fear of mark to market.

What they do is basically dumping the price risk to a counterparty who alternately dumps to another party, so on and so forth. By the time the same thing comes back in full circle, no one needs to worry about mark to market and earning surprises anymore. If a paper loss happens, they can point to the insurance and just claim that it is only temporary and offset by insurance, all financial statements will not be reflected and impacted.

Credit Default Swaps provides a vehicle which allows participants to hide any loss to a point where they really can't hide them anymore. They act as an earnings smoother and, worse, they hide the actual risk of investment bank holdings from the public. This is the reason why you see many strange things happening on Wall St. over the last several years.

For example, for a AAA rated CDO with a 50 basis point spread, investment banks will buy insurance from a very small 2nd tiered bond insurer (such as ACA) whose rating is only single A as a firm (now at triple C). If they believe a rating agency with AAA rating on this CDO, why would they want to cover it with a much less sub par policy redundantly which eats into their profit?

Another example, the GM example illustrated earlier. A $11B market cap with $1T Credit Default Swap. Just use home insurance as analogy here. If your house is only worth $200k, why in the earth does policy on your home have a combined notional amount of $20 million?

III. Third, and the most important to use credit default swaps, there is strong incentive to book the next 10 year's profit today.

Credit default swaps offer banks with the so-called negative-basis trade another accounting loophole besides the earnings smoother discussed above. Using the same example: a CDO with 50 basis point spread over US Treasures. Banks will buy credit default swaps costing them 20 basis points, but by doing so, even they seem to make less profit (50 vs. now only 30 bp spread), banks can actually book the difference in spread for the whole life of this CDO instantly, something called negative-basis trade.

If this CDO life is 10 years, banks can book the whole 10 years of phantom profits this year, even if this CDO defaults sometime in next 10 years. And I don't need to mention its implication to the bonuses of the structured product groups at Wall St firms, or hedge funds with 2/20 fee structure.

In other words, who cares whether this CDO defaults next year, let us just realize the next 10 years of bonuses today! There is a common secret at Wall St. -- it doesn't matter whether a product is good or bad, the only thing matters is how you structure it. As former Secretary of the Treasury, John Connely, said to European central banks in 1970s "It might be our currency (US dollar), but it is your problem". Same thing here. If CDO defaults, they have already bumped up the stock price, cashed out the stock options and vested shares, collected the yearend bonuses, now it is investors' problem.

This kind of accounting manipulation can fool people for a few years, but not forever, since the well of CDOs gets sucked dry very quickly when every single firm at Wall St. has found out about this and is doing it. Any firm owning a mortgage originator has a competitive "advantage" since it guarantees the source for the well. Now you know why Stanley O'Neal at Merrill Lynch wanted to buy First Franklin (a mortgage loan originator) so badly, because for every loan First Franklin originates, Merrill Lynch executives and their structured product groups will advance 10 years of their firm's earnings and future bonuses today.

Now you understand why Wall St wants to package and collateralize everything from residential to commercial, from mortgage to credit card to auto loan. Now you also realize what is behind the major shift and increase from traditional M&A fees in the good old days to the so-called trading "profit" in recent years "earned" by investment banks.

But at the same time, this raises a lot of questions on how real are the past earnings reported by both Wall St firms and hedge funds with large CDO profits. For example, if a hedge fund manager can trade minor reduction of profit (from 50 to 30 bps) with an immediate bonus of 10 times (1 vs. 10 years) paid today, what would he choose?

He would be nuts by not using credit default swaps to "structure" his CDO holdings. If the CDO defaults next year taking his fund under the watermark, it's no big deal. He already collected the money the year before. He can just close the fund and open another new one, raising money probably from the same sucker pool of investors. If you want to see a pyramid scheme, there is nothing more live and vivid than this.

How about those unbelievable earnings reported by Wall St. investment banks over the last several years? Frankly and openly, early this decade, investment banks had repeatedly expressed their non-satisfaction about relying on mainly the traditional banking fees from M&A and IPOs.

There is very little room for manipulation since they only get paid when a banking deal of M&A or IPO is completed. By discovering CDO and credit default swaps, they suddenly found their Holy Grail, with profit becoming more and more skewed toward the asset "structuring" (or manipulation) and trading side, representing the majority of "earnings" these days.

This kind of account abuse by using CDS is not alone. It happens in option ARM (adjustable-rate mortgages) market too. Homeowners (borrowers) for the first year or two pay a teaser rate of 2%, however in their financial statement, banks (lenders) report the full amount of interest, say 6%, as "profit", while they actually only collect 2%. The net 4% shortfall is added to the borrower's balance. Banks have nothing to lose, but homeowners see their balance increasing with home price dropping.

WaMu reported $1.4B profit from this kind of ARMs last year, while Countrywide Financial earned about $600M from them in 2007. How much of those earnings was real? How much real cash have they actually collected or will collect? They would be luck to collect only one third, with the rest they may never see. ARM default rate jumped from 1.5% from last summer to 5% by end of 2007. There are two big ARM rate resets coming, one this summer, another in October this year. By end of this year, I won't be surprised to see ARM default at double digits. The total outstanding ARM loans are estimated to be around $4-5 trillion, a 10% default will put $400B loans in default.

There are many other accounting manipulation and abuse in the mortgage market. For example, when a MBS (mortgage-backed securities) is sold to investors, banks will record cashflow from interest and servicing rights over the whole life of this bond instantly and up front, something called "gain on sale". Another example, since mortgages under "loans held for sale" at balance sheet need to mark to market, so banks simply move them to another category called "loans held for investment" which has no such requirement, only when they feel the losses are not temporary but permanent. Well, banks can always argue the current real estate crash is only temporary if you think long term.

If you are still using the last several year's earnings as a reference point, banks don't look very expensive today (setting aside the risk associated with all the off-balance items in the long footnote). But do you think those trading profits will return in the future? I really doubt it.

Accounting and legal loopholes will get closed by new regulations, and the CDO market will dry up for a long foreseeable future. Banks will not be able to return to their previous earning power without their trading "profit". Even if the economy comes back soon with lots of M&A and IPO deals again, which is very unlikely, the good old days of trading "profit" are likely gone forever.

This is why I don't see why all the sovereign wealth funds (SWF) are rushing to invest in Wall St. banks these days. There is not much upside, only a lot of downside. It is also very interesting to note that, as stated in the investment strategy of many SWFs, they all claim to seek a 5% stable annual return in very safe financial products.

However, they are investing in financial institutions such as Blackstone and Wall St. investment banks, which is everything but safe and stable. This totally contradicts their investment strategy. Nothing they have invested in can be regarded as safe and stable, let alone yielding a 5% annual return, maybe 5% fluctuation weekly if not daily.

Also no SWF has factored in the currency risk, maybe 5% in US dollar term, but probably negative 25% return in their own currency. There is nothing further from their stated investment strategy based on their investments so far, which creates a large credibility issue on everything else they have said.

Out of the outstanding $45 trillion credit default swaps, JP Morgan owns about $15 trillion, one third of the whole market. There is speculation that this is actually the main reason for the Bear Stearns' acquisition by JPM. Even Bear Stearns' CDS position is only around $2.5 trillion, the default of Bear Stearns will bring a shock wave of counterparty risk across the whole CDS market and inevitably expose JPM with its huge CDS risk to the global financial market. Who can afford to pay for this? Who has a large enough capital base to absorb such a loss, especially since these contracts are concentrated in only a few CDS derivative dealers like JPM? No one.

But at the end of the day, it always comes down to the deep pockets as in any liability litigation, where litigators will skip all the smaller players but jump on whoever has the deepest pocket and largest exposure and position, and JPM currently seems to fit the picture. When such time comes, all the other weaker and smaller players will try to dump their risk to JPM to unwind their positions. By buying Bear Stearns, JPM can probably postpone the CDS debacle for another year, but not forever. I expect JPM will eventually suffer very large losses in this area, bigger than one third of their market share. Bernanke, Fed and Treasury better get their helicopter and $500B cash ready.

Early this decade, Warren Buffett publicly turned against derivatives. "When Charlie [Munger] and I finished reading the long footnotes detailing the derivatives activities of major banks, the only thing we understand is that we don't understand how much risk the institution is taking," he told investors. He said "Derivatives are financial weapons of mass destruction (WMD), carrying dangers that, while now latent, are potentially lethal."

I believe what he was referring to at that time were not credit default swaps, but some very complicated derivatives such as exotic interest rate swaps. Wait until people become aware of the OTC CDS scheme which has no footnote in annual reports, no market, not regulated, no trace whatsoever, no clearing house, and everything depends on the credit and liquidity of the weakest player in the CDS chain. If an exotic interest rate swap can be called as WMD by Warren Buffett, I can't even come up with a name for the CDS. As Paul Volcker said last week the current crisis is "the mother of all crisis", I can say the CDS is the mother of the current credit crisis.

In general, the CDS is basically a Wall St vehicle used to manipulate loopholes in accounting and legal regulations in order to move and hide losses, to record future profits today, to manipulate, realize and increase reported earnings in today's financial statement, in order to receive in advance bonuses from future years now, with the help of their accomplices of both bond insurers and rating agencies.

At the same time, it is the same old game of phantom earning, quick profit, rip-off, manipulation, distortion and cover-up, played at Wall St since its very inception, only this time it is greatly exacerbated by the financial deregulations enacted during the Greenspan era.