By Jon Markman

ORIGINAL ARTICLE

By Jon Markman

Nearly seven decades ago, the eight months between Germany's invasion of Poland in 1939 and its invasion of France in 1940 was known as the "phony war" -- a period of escalating anxiety, denial, appeasement, danger and death, but nothing like the murderous global train wreck soon to follow.

Likewise, we may come to look at the period between July 2007 and January 2008 as a sort of phony war in the worldwide credit crisis, because although the market has fallen 15% since summer, there have been no defaults of key bonds or asset-backed securities. The curious lack of real blowups has led even seasoned observers to believe that fears were exaggerated and that chaos will be averted.

In reality, however, the skirmishes we've seen so far might be little more than a prelude to a deeper, harsher, longer decline than most yet perceive possible. And in a very postmodern twist, it is beginning to look like unexpected consequences of an investment instrument designed to mitigate risk could turn out to be the nuclear option that bombs the globe into the financial equivalent of World War III.

Banks left exposed

That instrument is the credit default swap, or CDS. It was developed as a way for bondholders to buy insurance against the possibility that companies might fail to pay their debts, and later it morphed into a way for big traders to actively bet on the likelihood of the default of bonds and other credit instruments. But what is only now becoming clear is that major U.S. and European banks and hedge funds bought up to $20 trillion worth of that insurance to offset their exposure to mortgage-related securities they owned. And those banks and hedge funds are discovering the sellers of the swaps may not pay up.

This leaves already deeply troubled banks virtually naked at just the moment they most need protection, as the pace of credit defaults is likely to accelerate this year so long as the Federal Reserve remains behind the curve in cutting interest rates. It's as if the banks already have pneumonia, and they're now being marched into a snowstorm wearing little more than bathrobes.

The problem surfaced to an important degree in a footnote to the news last week that Merrill Lynch (MER, news, msgs) would take an $11.5 billion write-down of bad debts for the fourth quarter. Of that amount, $3.1 billion was a write-down of credit default swaps that Merrill had purchased from bond insurer ACA Capital to hedge the risk of owning a lot of collateralized debt obligations, or CDOs, which are leveraged bundles of asset-backed securities. (In a typical CDS transaction, a debt holder or speculator agrees to pays 1.5% or more per year for $10 million worth of insurance on a specific slice of a debt security.)

This means that not only is Merrill unprotected against a default in the CDOs, but it has lost all the money it has paid for that insurance. It's as if you had paid $200,000 in premiums over the years in a $1 million life insurance policy for your spouse, and when a death occurs not only does the insurer tell you it's broke and can't pay -- but your premiums are down the drain, too.

Don't count on insurers

Several other major banks and brokers, such as the Canadian Imperial Bank of Commerce (CM, news, msgs) and Lehman Bros. (LEH, news, msgs), have been stiffed by ACA to the tune of billions, and all have let the insurer seek more capital before forcing it into bankruptcy. So the case gives us just a taste of what may come. Consider that ACA was no fly-by-night outfit. It was AAA-rated and met all standard benchmarks for safety. Yet those benchmarks now look ridiculous, as the company was allowed to provide $60 billion worth of guarantees on a capital base of just $500 million.

Can you imagine, as a citizen, if you were allowed to collect fees on $60 million worth of loan guarantees because you owned a house worth $500,000? It's nuts.