A Credit Default Swap Primer 17 comments
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At this point, it makes sense to explain just what a credit default swap, or CDS, is. They were the key reason for the demise of AIG (AIG), and for the fear that if they were not bailed out that the whole ball of wax would come unglued. Essentially it is an insurance policy, but an unregulated one (the State of N.Y. just recently said that it would start to regulate part of the market -- can you say closing the barn door?).
If you buy a bond from, say, General Motors (GM), you are lending them money for a set interest rate for a specified length of time. You face two sets of risks in doing so. The first is that they go bankrupt and don't pay you back. The second is that interest rates rise and the bond falls in value (think of bond prices and interest rates as being on opposite sides of a see-saw).
With a CDS, you could go out and find someone who will insure against the default risk. For a given premium, the seller of the CDS will pay off on the GM bond if GM goes belly up. Now, if it was from a real insurance company, the insurance company would be regulated and would have to hold enough money in reserve to pay you off in case GM actually did go belly up. This is just like how a Life Insurance company has to have enough cash on had to pay off on your policy in case you die.
However, since this is an unregulated market, someone can sell you a CDS and blow the money in Las Vegas. In that case, if GM did go belly up, you would just plain be out of luck.
In the case of life insurance, there are strict limits on who can take out a policy on you. You can take out a policy on your own life, and on close family members. In some circumstances you can take out a policy on your business partner, but beyond that there are not many people you can take out a policy on. You have to have what is called an insurable interest; you can't just wander the halls of the hospital looking for people who are unlikely to make it and take out life insurance policies on them.
This is not true for the CDS market. You are perfectly free to take out a "life insurance policy" on GM, GE (GE) or any other firm that issues a bond, and you do not have to be holding the bond. You can even take out a "life insurance policy" on the synthetic garbage the Wall Street has been pumping out.
This ability to buy insurance on things that you have no insurable interest in transformed this market into a huge casino. It is totally unregulated, and even the new steps by the New York State Insurance Commissioner, Eric Dinnallo, only covers the least egregious part of the market, where people actually have an insurable interest (i.e. hold the underlying bond). Regulation of this market was specifically prohibited under the Commodity Futures Modernization Act of 2001. That provision was slipped into the bill in the dead of night by our old friend Senator Phil Gramm of Texas -- now Vice Chairman of UBS (UBS).
People use this market to bet on the credit worthiness of companies, and often hedge funds will hold both long and short positions on the same underlying credit. For example (NOTE: figures are made up here, not a reflection of the actual creditworthiness of GE), the hedge fund might make a bet that it is worthwhile to get $200,000 up front and be on the hook for $10 million if GE defaults sometime in the next five years. Then after a few months, GE raises a bunch of capital which significantly strengthens its balance sheet and lowers the risk of default, so it can make a bet with someone else who would now be willing to take just $100,000 to bet that GE will not go belly up within then next five years. The hedge fund could have a perfectly matched book, so in theory they were totally indifferent if GE survives or not.
However, suppose that the person who they made the bet with goes bankrupt themselves and can't pay up. That hedge fund might then have a hard time paying its counter party. This is where the fear of "cascading cross defaults" comes in.
All this is to say that the CDS market has seen more growth than practically any market in the history of mankind. It is currently at over $62 TRILLION, up from under $1 Trillion a decade ago. It would not take a very big percentage of that market to fail to leave a very big mark on the world financial system. When the dust settles from all the current mess, bringing this market under control has to be high on the agenda.
I would suggest that the contracts be standardized and that they be traded on an exchange, where the exchange itself acts as the counter-party for each trade (this is how the commodity exchanges work). It might also make sense to require that any party buying a CDS have an insurable interest in the underlying bond (i.e. that they are using it to hedge, not speculate).
This however, is work for the next Congress and Administration. First we have to put out the fire with a well crafted and responsible bailout bill to prevent these cascading cross defaults from occurring. The original Paulson proposal was not well crafted, yet Congress doesn't appear likely to make significant improvements to the bill.
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This article has 17 comments:
This is one of the many reasons we don't need to give them a blank check to try to "fix it" themselves. They'll be sitting up nights trying to figure out how to "game" whatever rescue regimen is set up to their own benefit while we pay the bills.
Meanwhile, the Big Spenders in Congress just LOVE the idea of monetizing another $700 billion courtesy of the U.S. Treasury. In the unlikely event these moneys are ever returned to the Treasury, you don't think they actually plan to ever retire this debt, do you?
Of course not. It will provide them all the earmarks imaginable for useless spending projects in their districts for the next several years. And the Congress and the Wall Street wizards wonder why taxpayers are so cynical about their antics.
I suspect it's because actually having to balance budgets and pay taxes leaves us as the only ones left with some common sense.
Sure, buddy. Now go see if you can find someone who will insure you against your potential loss if your investment goes bad. NO ONE in their right mind would do that. That's the problem here.
On an exchange only those who pass the creditworthiness tests of their clearing firm and the exchange can trade, and they have to put up risk-based collateral. Why couldn't that work for the CDS market? It won't stop OTC trading of course but there are undoubtedly some participants who'd prefer the transparency and reliabillity of an exchange.
But they've gotten their miilions, so they couldn't care less. Of course, a parachute would still be nice. And that's EXACTLY what they're asking for now, courtesy of the taxpayers.
Meanwhile, the so-called "regulators" at the Treasury and the Fed (not to mention the Congress, which was being paid off) were peacefully asleep, which is what they do WELL.
I recall after Katrina when my bank went under water (literally!) and I needed access to my funds on deposit. I called the Altanta Fed and they were totally befuddled by my questions. Why, they'd never even dreamed about any such thing.
This is the VERY BEST TIME to get a handle on this total incompetence up and down the line. Rather than just throw more billions into these giant sinkholes we've allowed to be created in our names.
And your post really aids us in this effort. Thank you!
But I know this. EVERY idea's not necessarily a GOOD idea. How about if we simply PROHIBITED these types of transactions in the first place? Somehow the financial world survived without them for all of its history heretofore, and did just fine.
Agreed, not every idea is a good one. But how do we, as a nation, seperate the good ones from the bad ones in advance? Who gets to decide? What makes their judgment so reliable? Even the great ones get some things wrong, over time. Innovation, sadly, comes at a price. Transparency (which the CDS market does not have) is the first step.
So he must have been a consultant. Now what could he have possibly consulted about that was worth $90 million? Maybe on how best to go bankrupt, as it turns out.
Or perhaps his job was to know which members of Congress they needed to pay off to keep lawmakers from asking too many embarrassing questions about their business pratices and prospective future solvency.
If that was the case, he was worth every penny they paid him. Unfortunately, in the end it cost us taxpayers $200 BILLION to bail out this particular house of cards.
I try not to be too big a crackpot, really. Certainly real innovation is invaluable. The problem comes when people we have to rely on insist on putting their damn feet on the end of the scale, if you catch my drift.
And that's the problem! Before this is all over, I can promise you we'll be STUNNED by what we learn about what really got us here.
I've lived in both NYC and Washington. The former are generally alright, their jobs are making money. And some of them are pretty good at it working within the law.
It's the latter ones where the problem lies. Far from having our best interests at heart, they laugh at us and think us rubes. Let me tell you, Obama's cocktail party slip in SF about our "clinging to our guns and religion" was more telling than you'll ever know.
That's REALLY how many of them (in both parties) think. Including and ESPECIALLY the ones running the place right now!
Of course not. They're going to SPEND IT. And that's exactly why they want so desperately to approve it in the first place. They've already run through the TRILLIONS they call the Social Security "trust funds" (Right!), and they're vigilently on the hunt for fresh money.
Couldn't agree more. Polticians are in love with using the tax code to socially engineer electorally pleasing outcomes. Something-for-nothingi... plagues the budgetary process. Each little handout is small as a function of the federal budget, but very large to the organized interest demanding it, which can then deliver votes. Honest politicians (ha ha ha) would say: "I'm voting for XXX not because it's good for nearly everyone, but because its good for my job and the vocal, organized electoral minority supporting it." Inevitably, that which should rightly receive a collective response (poverty, transportation) gets shortchanged.
If people don't like how we're dealing with this problem, Social Security and Medicare, which are about 50x bigger, will blow everyone's mind.
I have been very concerned about the possiblitly that CDS can be used for manipulation and heartily agree with the suggestion that there be a requirement of insurable interest. As noted, lack of insurable interest has created a huge casino and the game is rigged.
Both the SEC and NY Atorney General are investigating the possible use of CDS for manipulative purposes. After the election, I suggest everyone press their congressment for action in making CDS subject to regulation - the original exemption was a serious error.
Though your comments were totally off-post to the article, which adequately explained the CDS ponzi system, I can't let your Republican talking points about this being a Democratic Fannie/Freddie-initiat... cause to the problem.
As the author rightly points out it was Gramm who literally inserted the regulation exemption for the Commodity Futures market.
We bought whole hog into a ton of manure that the way for all to get wealthy is to let the market work, cut taxes such that capital flows towards those with the capital, and get out of the way. That's exactly the picture that McCain has espoused and bullied around for 26 years (remember the Keating Five?)
Now for some shocking realities:
1. The top 1% control 40% of all financial wealth in the U.S. The top 20% another 52%, leaving the rest of us (80%) America's financial wealth at a whopping 8%.
2. In terms of inherited wealth only 1.6% inherit moe than $100,000. 91.9% receive nothing. Yet the "death tax" is the highest priority on the ultra-conservative agenda.
Now for some sobering reminders:
Under Clinton we enjoyed a $287 Billion SURPLUS that's now a $600 Billion deficit and national debt that has grown from $5.7 Trillion to 9/7 Trillion in just seven years.
It wasn't because Clinton was an economic genious. He simply chose folks who shared his philosophy of government and its role. I'll put my money in the hands of the guys that believe that it's the government's job to invest in the 80% of us that need practical ways to grow our own wealth (smart energy policy, infrastructure development, education).
Let's hear less grandstanding, yes, but let's hear more truth as well.
I reread my comments. Can you point me to where I blamed, or even mentioned, FNM, FRE or heaped blame on Democrats specifically?
When someone writes CDS you should think insurable interest and moral hazzard.
So who pays off the CDS? AIG. AIG backs more CDSs than any other compay by far, and AIG/US Treasury has been paying off CDSs at 100 cents on the dollar. Funny situation isn't it, where the US Treasury/Taxpayer has to either loan GM money to keep operating or pay off CDSs if GM goes into bankrputcy?
Heads you win, tails I lose.