I’m at the Economics 101 level. Can someone explain, in layman’s terms what Credit Default Swaps and derivatives are?
Thanks.
I got a business degree 20 years ago and I am somewhat confused.
I think it has something to do with buying debt contracts at a discount then getting the annuity at a higher rate.
Derivatives comprise a whole market of different financial instruments. Unlike the commercial banking industry, or the stock market, the derivatives market is "self-regulated" - primarily by the investment banks.
Credit Default Swaps (CDS's) are one segment of the derivatives market (probably making up about 1/15 of the market). Think of CDS's as bets in Las Vegas. There can be winners, losers, and pushes. The CDS market was valued at around $900 million dollars in 2001 (not actual dollars - but the total amount of "bets"). That grew to over $45 Trillion dollars by 2008 (see the problem here...).
A Credit Default Swap is a contract with a buyer and seller. The seller in this case might be an investment bank - and they "sell" asset-backed (could be mortgage) paper to the buyer. The buyer "wins" when the seller defaults, and the buyer gets the spoils.
Now, to make things more complicated - this is an international market and there can by many entities involved in CDS's for a particular tranche (or bucket of money). You have what are know as "counter-parties". These counter-parties can be greatly affected if something "out of the norm" happens to a particular contract.
So, if Paulson rushes in and starts affecting the CDS market you will see an "unwinding" of contracts all of the planet due to the "counter-party" exposure. It will literally implode on itself.
If Paulson doesn't do anything, then the "bets" that are set to go bad will continue to go bad. Liquidity in our market will be gone and we will enter a depression.
Pick your poison - but I opt for the depression because it will be shorter in duration because market forces will "self-cleanse".
Derivatives comprise a whole market of different financial instruments. Unlike the commercial banking industry, or the stock market, the derivatives market is "self-regulated" - primarily by the investment banks.
Credit Default Swaps (CDS's) are one segment of the derivatives market (probably making up about 1/15 of the market). Think of CDS's as bets in Las Vegas. There can be winners, losers, and pushes. The CDS market was valued at around $900 million dollars in 2001 (not actual dollars - but the total amount of "bets"). That grew to over $45 Trillion dollars by 2008 (see the problem here...).
A Credit Default Swap is a contract with a buyer and seller. The seller in this case might be an investment bank - and they "sell" asset-backed (could be mortgage) paper to the buyer. The buyer "wins" when the seller defaults, and the buyer gets the spoils.
Now, to make things more complicated - this is an international market and there can by many entities involved in CDS's for a particular tranche (or bucket of money). You have what are know as "counter-parties". These counter-parties can be greatly affected if something "out of the norm" happens to a particular contract.
So, if Paulson rushes in and starts affecting the CDS market you will see an "unwinding" of contracts all of the planet due to the "counter-party" exposure. It will literally implode on itself.
If Paulson doesn't do anything, then the "bets" that are set to go bad will continue to go bad. Liquidity in our market will be gone and we will enter a depression.
Pick your poison - but I opt for the depression because it will be shorter in duration because market forces will "self-cleanse".
You know that Private Mortgage Insurance (PMI) you have to take out if you don't have 20% equity in your house? It's supposed to pay the bank if you default on your mortgage.
Well, the big banks holding all those Mortgage Backed Securities (MBS - the bundled and sliced and diced crap mortgages loaned out lately to subprime lenders) took out similar insurance on these securities. These insurance policies pay off if those MBS's default, or even if they just fall below a certain credit rating.
AIG (that big insurer you've read about lately) wrote a lot of that insurance.
When Lehman and Fannie and Freddie each ran into nasty problems this last couple of weeks, it triggered a lot of that insurance -- AIG was obligated to pay out more than it had on hand. Kinda like home insurance companies would look if Cat 5 hurricanes hit Miami, New Orleans and Houston, dead on, all in the same hurricane season ... bankrupt.
This credit insurance is roughly what's called Credit Default Swaps.
Unfortunately, AIG writes a lot of other insurance as well, such as 90% of the insurance for commercial airliners. So if AIG goes under, the commercial airliners can't fly ... guess how long before they go bankrupt ... given that they already have their chosen bankruptcy legal firms on speed dial thanks to fuel prices ... not long.
In fact, short term commercial loans, whether overnight between banks or for less than 90 days with businesses, would dry up, as banks and businesses quickly stopped trusting each other any further than you'd trust a guy trying to sell you a used car in a dark alley late at night on the wrong side of town.
Money Market funds, that most investors keep their money in between other investments, are the primary source of these short term loans.
Last week, thanks to Lehman defaulting, the biggest, oldest, best known Money Market fund lost 3% of its value and had to put one week holds on withdrawals. This was starting to cause a major run on Money Market funds, with hundreds of billions being withdrawn.
That Money Market money is like the oil in your cars engine; without it, our banking system freezes up lock solid.
Credit cards, checks, banks, your paycheck, ATM machines, ... rapidly grind to a halt, within a couple of days. Trucks, planes and trains stop. Grocery stores sell what they have on the shelf, for cash only.
Those of us who have stockpiled ammo, whiskey and survival food get to gloat ...