Many of us have scant knowledge of the bond business, let alone all these new (to us) credit derivatives. You are supposed to have a certain fraction of your investments in bonds versus stocks. The closer to retirement you are, the more bonds you should own. Of course, the complications are too much for many, so we tend to let mutual fund managers do the hard work – we just have to pick the right fund and hope the bond to stock ratio is right for our individual ages.

When you buy a bond, you are lending money to the company. You are buying their debt. They pay you interest. At a predetermined (maturity) date, they “call” it and pay you back the face amount. Let us hope you did not pay more than the face amount to begin with. Moreover, there is a chance that the bond can be sold later for more than what you paid for it. If you sell before maturity, you could get back more or less than the face amount. It is easy to see why the earnings from a high-quality bond is called “fixed income.” That makes it more conservative than stock investing.

It has to do with quality. However, even the best rating of quality, AAA, has been put on bundles of low-quality debt. The ratings basically should tell you the product is high quality, investment grade or high-yield (read “junk bond”). This has included sub-prime mortgages. They have been bundled, and then sliced into “tranches.” The quality mix is supposedly better for the combination. These structured “financial products” are a type of bond, called Collateralized Debt Obligations or CDOs. The debts are backed by assets.

Enter Insurance

The bonds you might buy are possibly in industrial companies, or they could be the bonds of banks and other financial institutions who have bought CDOs. These institutions know quite well that the AAA rating is questionable. There is some risk involved. Just in case they turn out to be junk bonds, the institutions buy insurance. If the underlying debtors default (stop paying or walk away from their mortgaged homes), another party guarantees full payment of the devalued paper. These insurance agreements are known as Credit Default Swaps (CDSs).

For a fee of a fraction of the total CDO, the CDS makes the bond you bought safer. Some of the insuring institutions providing the CDSs want to spread the risk even further. Therefore, they buy insurance from yet another party. They give a third party a small slice of their profit. The problem is that when a default occurs, it is not the same court that handles the refusal to pay in the first CDS provider case as might handle the other one.

Is that as far as it goes? Two CDS per CDO? Or are there more parties involved?

The Size of the CDS Market

It has now become common knowledge, at least on Wall Street and among bankers, that the total world CDS exposure is $45 trillion. This is more than half of the global banking system's assets, and over 3 times the entire GDP of the United States . This clearly indicates that multiple CDS purchases per CDO have been made. It is an immense set of rows of dominos.

The expected default rate (1.25% to 2.5%) will require that some institutions cover the damage with $250 to $500 billion. No small combination of J. P. Morgan sized banks would be needed. Note that JPM alone holds $15 trillion of the CDS pool.

It could require the Federal Reserve to step in. But even the Fed would be hard-pressed to simply give that amount to these losers. It is reported to have had some $800 billion in reserves at the beginning of the year. Some $200 to $230 of this has already been plowed in to “injections of liquidity” in troubled U.S. banking.

If that does not do the trick, what kind of collapse might follow? The above numbers assume that the non-defaulting pool of CDOs would be unaffected. But as the news would leak out on dominos falling, would not owners of a lot of bonds begin to doubt the quality of their holdings and offer to sell them? Would not this cause the market price of certain tranches to fall?

Force Majeure

The final hit could be for a government that is already close to $10 trillion in debt to step in. Can you hear the printing presses start?

It would cause critical world inflation within months. The federal government could lose its AAA credit rating. It would amount to a force majeure, the government admitting it will not ever repay the bonds that make up the national debt, i.e. the government defaults.

If you wonder why the price of gold went to peak levels in recent history, only to drop back drastically, look to parties who were interested in keeping the “strong dollar.” The value of one dollar created in 1914, when the Federal Reserve was created, has now fallen to four cents (about 95%). How far must it fall before a new currency appears, the Amero?

True Money

Money needs to be independent of the banks and of the federal government. Money is a market reality, a market factor. It needs a free market; it needs competition to be kept fair and trustworthy.

Money, the means of exchange and the storage of value for future use, needs to be based, not on debt, but on something of real value. The medium needs to be something that has a clear traceable history (an apostolic succession) from a market where it had and still has a solid value (industrial, cosmetic and other uses) and be durable and able to hold its value.

A monetary system based on U.S. Treasury bills, bonds and notes is a flimsy paper system, a fiat monetary system (fiat being Latin for the “let it be” guarantee of the debtor government). The self-serving interest of the government, the Federal Reserve and the whole banking system should no longer be seen (should never have been) as our trusted friends or servants. This is becoming a kind of banking fascism or socialism. Where do we draw the line between government and big business?

If you want to look after your own true self-interest, get into gold, but do not trust a bank or dealer to hold it for you or keep it at home. Big Brother confiscated it from people once before, in 1933. They could do it again, and the safekeeping of even foreign gold vaults could be without a real guarantee.