A market correction, an economic recession, and a financial crisis are very different things.  A market correction is routine in a healthy stock market and is a necessary step for the market to go higher.  An economic recession is a routine part of business cycle and is a necessary step for the economy to continue growing.  A financial crisis is much more sudden and severe.  Originating in the financial sector of the economy, it quickly cripples the entire economy and stock market.  Remember the Great Recession of 2009?  It started as the Global Financial Crisis of 2008.

I have no fear of market corrections nor economic recessions.  But, I am scared-to-death of a financial crisis, which will likely first appear as a derivative blow-up.

Argentina now poses such a risk, as they have been declared in technical default.  This is not a case of Argentina saying they will not pay their obligations.  They are saying that past bondholders demanding payment are NOT entitled to any payment now, as those bonds were “crammed down” to a lower value over a decade ago.  Then, a U.S. court said that U.S. banks acting as agents for the current bondholders may not pay out interest that is due on new bonds, unless certain past bondholders are repaid the full face value of the bonds.  Argentina has ample funds to keep the interest current but not to pay previously crammed-down bonds.  They have now been declared in technical default.  So, why is that important?

Bondholders who are afraid Argentina will never pay the bonds are free to buy insurance against a credit default.  This insurance is usually expensive but not outrageous.  Early last week, it would cost you $2.7 million to insure $10 million of Argentine bonds, which is outrageous enough.  By Friday, it would cost you $4.2 million.  This insurance is called a credit default swap.  If I sell you a credit default swap, I get $4.2 million but am still exposed for $5.8 million, because I may have to pay you $10 million.  To protect myself, I then buy a credit default swap from somebody else.  So, a credit default swap stands behind another credit default swap.

If I am a bondholder and bought the first credit default swap, I know who is responsible for paying me.  But, if he is unable to pay, I don’t know who is behind him, if anybody.  The big picture is that we don’t know who is on the hook for how much.  Who is holding the bag?

If you see any announcement next week that some financial institution has defaulted on a credit default swap, consider decreasing your equity exposure and increasing your cash.  There is a huge difference between a bond default and a derivative default.  Keep your antenna up this week!  I certainly will !!