It was sickening enough when British oil giant BP set new standards for corporate scumbaggery in the Deepwater Horizon oil spill, turning the Gulf of Mexico into its own personal toilet and imperiling entire species of wildlife in an attempt to save a few nickels. But with the Gulf geyser finally capped, there's still a way for BP to cause an even more unthinkable disaster: an AIG-style, derivative-fueled financial shitstorm. If the company decides to declare bankruptcy — a very real possibility with these bastards — it could trigger chaos in our casino system of finance, underscoring the insane levels of leverage and systemic risk we have left in place, even after the global economic crash of 2008.
The first serious whiff of trouble came on June 15th, when Barack Obama manned up and went on national TV to tell the nation that he wasn't going to let BP worm its way out of this one. "We will make BP pay for the damage their company has caused," he declared, vowing to push BP to set aside $20 billion to clean up its mess and compensate victims.
That sound you heard the very next day was Wall Street's collective asshole slamming shut in terror. If the government was seriously going to stick BP with the tab for the worst environmental disaster in America's history, then there was suddenly a real chance that one of the most lucrative moneymaking machines the world has ever seen could go bankrupt. And if there's one thing we've learned from the disastrous implosion of AIG, there is no such thing anymore as a giant company dying alone.
To Wall Street, a firm like BP isn't just a profitable energy company with lots of assets like oil rigs and pipelines and gas stations — it's also a corporation that routinely borrows hundreds of millions of dollars to keep its business up and running. And as a Grade-A corporate borrower of the first rank, BP and its debt are at the center of billions of dollars of gambling action on Wall Street, in the same way millions of home mortgages fueled the vortex of credit-default swaps and other derivatives that crashed the world's economy in 2008.
In today's casino economy, you don't need the permission of a company like BP (or a homeowner in Florida, or a country like Greece) to place a bet on their debt. You don't need to put any money down to back your losses. And there's no limit to how many times you can wager on the same outcome: A company may have only taken out $1 million in loans, but scores of banks, hedge funds and other financial players might cumulatively wager $100 million on whether or not the company will pay off that single million on time. That's why, if a behemoth as large as BP goes under, it can cause losses beyond its own liabilities: Derivatives now comprise a virtually unregulated shadow economy that is 100 times larger than the federal budget.
The day after Obama's speech, Wall Street suddenly decided that BP wasn't such a good bet anymore — a fact reflected by the dramatic repricing of credit-default swaps involving the company's debt. A CDS is just two financial actors wagering on whether or not a company is going to default on its loans. When the CDS price or "spread" is low, all that means is that the bookies selling the swap — usually America's biggest banks — aren't charging you much to bet that the company will fail. A low CDS spread is like the long odds you'd get if you walked into a Vegas casino and wanted to bet on the world ending by nightfall: A confident bookie would look out the window, see no missiles falling, and be happy to take 10 bucks from you in exchange for a promise to pay out a million if Armageddon took place before dusk.
Before the disaster in the Gulf, BP had similarly low odds. On the day the spill started in April, the cost of a five-year CDS on the company was 43 — meaning it cost just $43,000 to place a bet that BP would default on $10 million of its debt within five years. "For comparison's sake, the price of U.S. Treasuries during the same time period was in the 35 to 40 ballpark," says Otis Casey, an analyst who tracks CDS prices. Before the spill, in other words, the market considered BP to be almost as safe a bet as the U.S. government. Given the bargain-basement price, investors happily piled up swaps on the firm's debt, often as a way to hedge other bets they'd made in the energy sector. If their investments in Gulf oil extraction went south, say, the default of BP would serve as a form of insurance, helping to cover their losses.
But the spill changed all that. By the first day of June, swaps on BP had risen to 168; by June 15th, just before Obama gave his speech, they had soared to 494. The next day, after BP agreed to set aside $20 billion to cover its liabilities in the Gulf, the number shot up to 614 — meaning it now cost a staggering $614,000 to place a bet on $10 million of BP's debt.
The numbers were eerily similar to AIG's swap numbers shortly before it imploded in September 2008. In three days before the fateful bailout of the firm, the cost of the same five-year CDS deals on the insurance giant soared from 499 to 646 to 824. Like BP, AIG had once been considered among the safest bets in the world, with its swaps regularly trading below 30 before the financial crisis. But as the BP spill worsened through the summer, the market clearly panicked at the prospect of another AIG-like collapse.
"You can't tell me that every derivative dealer didn't crap his pants at first," says Eric Salzman, a former director at Credit Suisse. "They all had meetings to figure out 'What's our exposure to these guys, and what's the exposure all our counterparties and competitors have?' "
It got worse. On June 20th, a few days after Obama's speech, the ratings agency Moody's released an ominous report with the seemingly obscure title "BP Credit Deterioration Hurts CSOs Referencing BP." The report said that large numbers of a type of derivative contract now in circulation around the globe — a beast called a collateralized synthetic obligation, or CSO — were tied, in one way or another, to the fate of BP's debt.
The very existence of these CSOs is a testament to the extravagant insanity of the derivatives market. If a CDS is two bankers sitting on a bench placing bets on whether or not the oil company across the street defaults on its loan, a CSO is a giant basket of those CDS bets whose contents can be chopped up and sold as securities-like products to whatever moron is interested in buying them.
Selling not just actual debt but bets on debt is the essence of the derivatives market, where the aim is to create more shit for the banks to sell by magically creating loanlike products out of thin air. "Synthetic lending," is how one market analyst put it. Imagine a Foot Locker floor manager sticking a new set of Nikes in front of a three-way mirror and selling off each of the images as a new pair of sneakers, and you get an idea of what we're dealing with here. According to Moody's, there are a hell of a lot of these doppelgänger BP bets in circulation. "We reviewed our entire universe of outstanding CSOs," the firm reported, "and determined that exposure to BP and its rated subsidiaries appears in 117 (excluding CSOs backed by CSOs) transactions, which represents approximately 18 percent of global Moody's-rated CSOs."
In other words, a full 18 percent of these complex bets in circulation are tied in some way to BP's future. And note the frightening parenthetical comment, which reveals that the Moody's analysis conveniently excludes "CSOs backed by CSOs." Wrap your head around this: If a CSO is a basket full of bets on loans, then a CSO backed by a CSO (a thing called a "CSO squared") is just what it sounds like: a basket full of baskets filled with bets. When I called Moody's to ask how many of these mutant debt-clones are out there in circulation, the firm said it didn't have that data.
This sort of uncertainty about the potential impact following the collapse of a major firm like BP is the heart of the problem. AIG went down because of a vicious cycle of variables: A downgrade in the company's credit triggered collateral clauses in some CDS deals that forced the company to post so much cash to pay off bettors that its credit got downgraded again — triggering still more collateral clauses, leading to more cash losses, leading to the death spiral of September 2008. The disaster took even AIG's top management by surprise, because almost nobody knew about those collateral clauses; the markets simply had no idea who was going to have to pay, or how much, if the company defaulted. And fear of that unknown is a big part of what drove the panic on Wall Street in the weeks before Lehman and AIG started circling the drain.
Now a similar, if perhaps less dramatic, fear exists with BP, which has already seen its credit downgraded multiple times as a result of the spill: On the day of Obama's speech, the Fitch agency sliced the firm's credit rating all the way down to BBB, just above junk status. In the months and years to come, BP will no doubt have to produce large sums of cash to pay for cleanup costs and lawsuits and penalties — and each time its cash situation deteriorates, its credit rating may worsen, which in turn could mean big betting losses in derivatives like CDSs and CSOs and CSO squareds.
The lack of transparency in the derivatives market means that nobody has any idea what will happen or who will be affected if BP goes under. Nobody knows whether a BP credit downgrade will trigger losses in any of those 117 CSOs, or whether losses would only come in the event of a bankruptcy. ("It depends on a lot of factors," says Moody's spokesman Thomas Lemmon. "Every one of them can have different characteristics.") Nobody knows who's taking those billions and billions of dollars of CDS bets against BP, meaning that nobody knows which federally insured banks will be fucked if BP defaults. (Asked if the identities of the CDS sellers is knowable, market analyst Casey had a blunt answer: "No.")
It's not even possible to more than vaguely quantify the dollar amount of losses that might ensue if BP goes under. We know, because the Depository Trust and Clearing Corporation posts these statistics, that at this writing BP is listed as a "reference entity" on some 3,413 derivative contracts worth somewhere in the vicinity of $18 billion — meaning that roughly that many derivative bets hinge on the question of whether or not BP defaults. But we don't know who those bettors are, and we don't know how many CSO-like side bets are pegged to those bets.
In short, nobody knows what might happen if BP goes down. The general consensus is that the company probably isn't at the center of as many economic webs as Wall Street firms like Lehman Brothers or AIG — but that doesn't mean it couldn't touch off a financial tempest of global proportions. "It would be huge," says Peter Kaufman, president of the investment bank Gordian Group. "I don't believe it would have the interconnectivity of an AIG or Lehman, but it would be big."
The irony of all of this, of course, is that BP could end up serving as the ultimate example of the myopic incompetence of Wall Street gamblers. Twice in two years — first with AIG, now with BP — the global investment community has been badly burned by British-based corporate executives who looked from afar like highfalutin', Savile Row-clad royalty, but proved upon closer examination to have been managed by greed-sick, corner-cutting morons from the Crazy Eddie school of business ethics.
You would think Wall Street would have known better than to bank on BP, given the company's track record of idiocy and double-dealing. Long before Goldman Sachs agreed to pay a record $550 million in fines this year for defrauding its own investors, BP had already been forced to cough up a similarly massive settlement for financial shenanigans: In October 2007, the oil giant agreed to pay a whopping $303 million for manipulating the propane market — a scheme that jacked up prices for some 7 million Americans.
BP's attempts to make money in a legitimate fashion, meanwhile, have been plagued by faulty equipment and dangerously shoddy management. Well before the explosion at Deepwater Horizon, which incinerated 11 workers, the company had put employees at its refinery in Texas City at risk by neglecting to fix faulty equipment in order to grease its bottom line. "We have never seen a site where the notion 'I could die today' was so real," observed a consulting firm hired to inspect the facility in 2005, two months before a blast killed 15 workers and injured 170. The government, which ultimately discovered more than 300 safety violations at the refinery, concluded that the explosion had been "caused by organizational and safety deficiencies at all levels of BP." Regulators fined the firm $21 million — the largest penalty in OSHA history, until it was topped in August by an additional fine of $50.6 million for violations at the same refinery.
The fines must not have been that sobering to BP, however: Within a year of the fatal explosion in Texas City, a corroded pipeline that the company had failed to fix was dumping 267,000 gallons of oil into the waters of Prudhoe Bay in Alaska. For that environmental nightmare, BP ended up paying another $20 million in fines.
By that point, the company was also dealing with a disaster it had created in the Gulf at an oil platform called Thunder Horse. In what one engineer called a desperate attempt to "demonstrate to their shareholders that the project was on time and on schedule," BP rushed the unfinished rig into service — only to have a valve that had been installed backward cause the whole thing to list over and nearly sink. Since the platform wasn't fully operational yet, there were no major spills — but BP lost hundreds of millions of dollars and set its drilling back three full years.
Thus it wasn't exactly a freak occurrence when BP earlier this year blew off safety warnings about Deepwater Horizon. On the contrary, the disaster was a perfect expression of everything BP had come to stand for: serial inattention to safety in a blind rush for profit, in a business where bad safety procedures are about the only sure way to lose money. And yet, at the start of this year, Wall Street investors considered this incorrigibly bumbling corporate comedy act to be almost as good a bet as the U.S. government. Yes, the firm is cash-rich and has mountains of physical assets — but at some point, who you are and how you operate has to count for something.
Which brings us to the most important point underlying the billions of dollars in bets that have been placed on the company's debt. Right now, every high-ranking BP executive is working hard to convince us that the oil giant won't eventually try to weasel out of paying for its galactic mess by filing for bankruptcy. Kenneth Feinberg, the lawyer hired to administer the firm's $20 billion cleanup fund, said shortly after Obama's speech that a BP bankruptcy would be "a disaster for the people of the Gulf" and is "not an option." Then-CEO Tony Hayward also assured investors that BP has more than enough cash to survive: "The strength of cash-flow generation in recent quarters," he said, "has provided us with a balance sheet that allows us to fully take on the responsibility for the Gulf of Mexico response."
The Oil Pollution Act of 1990 caps the firm's post-cleanup liability at $75 million — a number that BP insists it can afford. But according to that same act, the cap is rendered meaningless if BP is found criminally negligible in a court of law. Given its negligence in the Gulf, that's a very real possibility — meaning that the total costs could run to more than $100 billion, a number that would kill the firm for sure.
In either case, however, expecting BP to do all it can to avoid bankruptcy just for the pleasure of avoiding a crash in the derivatives market and paying out lawsuit awards to oil-stained hicks — that runs completely counter to everything we've come to learn about this company. If BP's executive swine think they'll get off more cheaply filing for bankruptcy, they'll do it in a minute. "They want to pay out as little as possible," says Kaufman, the bankruptcy expert. "Why would they want to pay out more than they have to? Because they're great humanitarians?"
To prevent BP from ducking its responsibilities, Rep. John Conyers of Michigan has introduced a bill that would bar the company from declaring bankruptcy without the OK of at least half of all potential victim-plaintiffs. That bill passed the House and is now headed for the Senate. If it winds up being signed into law, the potential exists for a dramatic confrontation between England and the United States over whether a British-based corporate gangster should be allowed to slash his own wrists to avoid paying claims to pissed-off fishermen and other NASCAR-loving plaintiffs along the Gulf Coast.
In any case, since Obama made his fateful "the limeys will pay" speech, the markets have calmed down a little on BP. The current price of a five-year CDS on the firm's debt has plunged to 240, where it has been holding steady for weeks. But in a betting age, bet on this: The world's reigning corporate villain is still considering a bankruptcy move that could have dire consequences not only for U.S. taxpayers but for the entire global economy. "Unless they're being completely negligent," says Kaufman, "they've got teams of people going over various strategies. And I guarantee they've got a team on bankruptcy."
It may very well be that BP won't go bust — or that, even if it does, it won't cause a financial catastrophe. Any analysis of derivatives is by its very nature inexact, full of maybe's and could be's and possibly's, and that's precisely the problem; we continue to operate a massive alternative economy of unrestrained gambling that keeps everyone in the dark. AIG should have been the wake-up call that got us to shine a light on this dark market, but Wall Street has fought hard to preserve its deregulated betting parlor. Which leaves us right where we were two summers ago: wondering if BP or some other corporate fiasco is going to cause the next global panic — and wondering why we still permit this derivatives-fueled casino to remain open.
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