What are Credit Default Swaps? By Jason Galanis

An Insurance Blog by Jason Galanis

Just recently I (Jason Galanis) was taken aback when my daughter, who was smart enough to stay out of my business, asked me whether a Credit Default Swap was insurance or a derivative. My answer must have seemed haltingly disingenuous as I informed her back that it was quite frankly both. Insurance to the extent that it provides a guarantee on a bond yearly for a basis point percentage of its value. It was a derivative to the extent that it, like a call option, had an underlying relationship with a security.

The real trick with Credit Default Swaps, however, is they were never treated as insurance products thus never had to secure any reserves against what payouts might be made. And that is understandable as they were created in the laboratory that was the investment bank of JP Morgan. Their true brilliance may have been the fact that they straddled both worlds without firmly placing a foot in either camp.

However, when the credit crisis began in 2008 these seemingly simple innocuous instruments almost bankrupted the insurance giant AIG. How was it that people at the top layer of sophistication made so many mistakes. The answer is that the economy, like the space shuttle, is a giant complex machine for which no one knows all the answers and no one can see everything going on at once.

It started at home in America with the mortgage business where sub prime lending hit a peak. Every family was looking to buy a home and would be entrepreneurs were looking to buy several as investment properties. This was enabled by the banks need to lend which was fed from the markets need for paper. This paper was created from the invention of another derivative no more pernicious than the CDS but one which could be used improperly enough to almost cause another Great Depression; the MBS.

Mortgage Backed Securities had been around since Salomon Brothers put them together decades earlier. The difference was the quality of paper that was filling the new bond. Shrewd businessmen had convinced rating agencies of the actuarial sense that the US housing market had never significantly headed downwards and as such any grouping of mortgage bonds deserved a triple A rating. This was the classic example of extremely elite investment bankers getting over on their lesser counterparts who very likely wished they were sitting in the chair across the table.

Nevertheless, neither CDSs nor the MBSs are responsible for the turmoil afterwards. Both were innovative instruments that have the power to do a lot of good for mankind. It is the human error and greed that turned what should have been helpful tools into “weapons of mass destruction”. So how was it that they created the demise of insurance giant American International Group? That is a story for my next posting.

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Could Russian Help Have Stopped the Boston Bombings? By Jason Galanis

“Relations between the U.S. and Russia have deteriorated to the point where they are arguably as bad as they have been since the Cold War” said Jason Galanis. Adding fuel to the fire is a new report that investigated FBI, CIA, and Homeland Security actions surrounding the Boston Marathon bombings on April 15, 2013 where three people died and more than 200 others were injured.

While no evidence was found that US government agencies could have done more to prevent the bombings, the report did raise questions about what would have happened if Russia shared the intelligence it had regarding wiretaps of one of the suspects before the bombing.

In 2011, Russian officials told the FBI that one of the bombers, Tamerlan Tsarnaev, showed signs of religious extremist behavior. However, when the FBI pressed for more details, they received nothing. Also, Tamerlan’s travels to Russia in 2012 exhibited highly suspicious behavior that was not passed on to the FBI until after the bombings.

According to the top Democrat on the House Intelligence Committee, C.A. “Dutch” Ruppersberger, “We will always ask ourselves what more we could have done to prevent this or another tragedy. What we may never understand is why the Russians didn’t share more with us to aid in the FBI’s investigation.”

These accusations come at a perilous time for U.S. and Russian relations and will just add fuel to the fire. It is not a good sign for the world economy for two of the largest countries in the world to be so nearsighted that counter-terrorism efforts take a back seat to brinksmanship diplomacy. Unfortunately it does not seem like either side will be backing down any time soon.

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Jason Galanis Discusses The Not So Typical EADS and BAE Merger

Beverly Hills, CA, – Jason Galanis has always tried to take a top down approach to investing because I believe the macro picture can change everything. That does not mean I do not believe in bottom up analysis; a company run well can survive in any weather. Is that true of relationships as well? In particular the supposed “special” relationship enjoyed between the United States and the UK. I believe there is a macro economic event playing out right now that may give us the clue.

The merger between EADS and BAE is not a typical merger for many reasons. For one both the French and German state hold shares in EADS. Second, BAE holds a special security arrangement with the United States, which has blossomed quite profitably in the recent expeditionary presidency of George W. Bush to $14 billion in revenues and employment of some 40,000 people in 40 states.

But, as we all know, all good things come to an end. With a war weary American public and a more laid back policy on foreign intervention (notice the back seat on Libya and the non action on Syria) BAE is not doing the kind of business it was during the Bush years. Couple that with a weakening of the financial sector-the UKs biggest industry- and European woes in general and it is not surprising that BAE would like a partner.

But does the threesome make any sense? It was argued recently that even the Franco German pairing made little sense. New products were late to market many times and factories made parts in disparate sections of the company that ultimately did not work together causing delays. The EADS CEO former German paratrooper, Tom Enders, says it is a perfect fit. Shareholder who perhaps disagreed with the CEOs position let the market know with a 12% dip in the EADS share price.

However when you are talking mergers and acquisitions this is par for the course. There is a reason information close to such deals is valuable and there is a whole hedge fund industry that makes money going long the acquiree and short the acqiuerer. However, there are those on the BAE side that say this is exactly the wrong time for a merger as the company is just starting to come out of its funk from slumping American security spending.

Is this simply posturing? Possibly yes. Each side is going to make the strongest case it can for its own interests. However, anyone in the business knows that there is no such thing as a merger of equals. And in this case BAE stands to become junior partner with 40% of the new company with 60% to the new owner. And this is where things get a bit messy. The security arrangement BAE has with America will not continue into a junior partnership with a Franco-German company.

And this is the sum of the story: a United Kingdom forced to chose between Atlanticism and further integration into the faltering union they already hold one foot out of. In a way, the British have a very privledged place in the world; coveted by both America and Europe yet coy with both. And the decision by America and the reaction by the Brits may determine where this relationship is going.

So I can here the next question; where is the punt? And that is the real trick. Rarely are things in life binary. When I touched down in Macao 10 years ago I saw it right away. A gambling hungry populace of billions of people served by a single enclave; where could things go wrong. But when you mix politics into investment the answer is almost anywhere anytime.

Do I think the merger will go forward; yes I do. Am I long on it? This to me is a microcosm of the Euro experiment; a move towards not just saving the Eurozone but enhancing it as well. And I answered this question when writing previously about the euro currency; my money is in Asia, in fact, it has been since that trip to Macao. But it does not mean I am not intrigued by this tipping point event that currently has the world in its grip. We will see how it plays out.

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