Credit Default Swaps: The Next Crisis? - March 2008

TIME ^ | Monday, Mar. 17, 2008 | By Janet Morrissey

[dennisw]

As Bear Stearns careened toward its eventual fire sale to JPMorgan Chase last weekend, the cost of protecting its debt, through an instrument called a credit default swap, began to rise rapidly as investors feared that Bear would not be good for money it promised on bonds. Not familiar with credit default swaps?

Well, we didn't know much about collateralized debt obligations (CDOs) either — until they began to undermine the economy. Credit default swaps, once an obscure financial instrument for banks and bondholders, could soon become the eye of the credit hurricane. The CDS market exploded over the past decade to more than $45 trillion in mid-2007, according to the International Swaps and Derivatives Association. This is roughly twice the size of the U.S. stock market (which is valued at about $22 trillion and falling) and far exceeds the $7.1 trillion mortgage market and $4.4 trillion U.S. treasuries market, notes Harvey Miller, senior partner at Weil, Gotshal & Manges. "It could be another — I hate to use the expression — nail in the coffin," said Miller, when referring to how this troubled CDS market could impact the country's credit crisis.

Credit default swaps are insurance-like contracts that promise to cover losses on certain securities in the event of a default. They typically apply to municipal bonds, corporate debt and mortgage securities and are sold by banks, hedge funds and others. The buyer of the credit default insurance pays premiums over a period of time in return for peace of mind, knowing that losses will be covered if a default happens. It's supposed to work similarly to someone taking out home insurance to protect against losses from fire and theft.

Except that it doesn't. Banks and insurance companies are regulated; the credit swaps market is not.

[Clintonfatigued]

Does this mean another bailout is on the way?

[the invisib1e hand]

this is way old news...I’d read Time for CDS info about like I’d read the Enquirer to plan my vacation.

[Uncle Miltie]

The trouble with Credit Default Swaps, if I understand them correctly as insurance against default, is that there is not enough financial wherewithal anywhere in the world to insure that much debt.

The insurance companies were generating insurance that they could not cover in a significant down-turn. We are there, and now the insurance companies will go belly up because they issued more insurance than they could actually back with cash.

Whoops! Chapter 11 experience for you, boys.

OBTW - THE SOONER THE BETTER, BUSHIES!

[Post Toasties]

It turns out that CDS are not anything approaching the real problem here.

[webstersII]

“It turns out that CDS are not anything approaching the real problem here.”

Please explain.

[Post Toasties]

It is generally acknowledged that our current economic crisis was precipitated primarily by the collapse of Fannie and Freddie.

As an example of the actual impact of CDS to date, CDS which totaled trillions (as the Time article calculates them) for the $100 Billion Lehman Brothers collapse were settled for a few billion dollars. And as everybody is aware, it turns out that even Democrat Paulson has decided there is no pressing need to immediately allocate much of the $700 billion bailout money that was voted for by Congress, which certainly would not be the case if CDS were significantly contributing to our current woes.

In the final analysis, the obsession with CDS resulted from a mixture of ignorance and a desperate attempt by the Left to deflect criticism from Democrats in Congress for causing the real estate bubble and the current economic collapse. We should not exempt CDS from regulation, but insisting on being distracted by an obsession with them to the extent that we don't deal with the primary issues threatens to kill us economically.

[HawaiianGecko]

 

   I have no idea what this all means, but it was an easy read and very instructive.

AIG’s Dangerous Collapse

& A Credit Derivatives Risk Primer

by Daniel R. Amerman, CFA | September 17, 2008

Overview

While it may look superficially similar to the recent implosions of such investment giants as Fannie Mae, Freddie Mac and Lehman, the takeover and bailout of AIG is quite different, and means that the market is entering the next and even more dangerous phase. What is driving the fall of AIG – and potential government losses that may far, far exceed the $85 billion bailout announced late on September 16th - is not mortgages or real estate (directly), but fears that AIG’s huge, global credit-default swap positions will unravel. The $62 trillion dollar credit derivatives market is 50 times the size of the subprime mortgage derivatives market, and is indeed larger than the entire global economy.

Unfortunately, few people understand credit derivatives, or the full risks to the United States and global markets and economies. In this article, I will take a Credit Derivatives Primer that I published in the spring of 2008 - which anticipated this exact type of event - and update it for the current situation. Through reading this article, you should be able to greatly increase your knowledge of what credit derivatives are, and why they are a far greater danger than subprime mortgages. We will end with introducing some concepts about how individuals can protect themselves and even profit from these unprecedented market conditions – something you won’t find in recent financial history or conventional investments.

The Rapid & Dangerous Collapse of AIG

“The particular risks that brought the company (AIG) to the brink of bankruptcy seem to lie not with its core insurance businesses but with its derivatives-trading subsidiary AIG Financial Products. AIG FP, as it's called, merits a mere paragraph in the nine-page description of the company's businesses in its most recent annual report. But it's a huge player in the new and mysterious business of credit-default swaps: derivative securities that allow banks, hedge funds and other financial players to insure against loans gone bad.” Time, September 17, 2008

On September 1st, few knew that AIG, the largest insurance company in the world with over $1 trillion in assets, was in deep trouble. By September 12th, the rumors about major trouble were everywhere. By September 15th AIG’s corporate life expectancy was being measured in days, and the question was: bankruptcy, buyer or bailout? By the evening of September 16th, the federal government had massively intervened, making an $85 billion loan to AIG in exchange for a controlling 79.9% equity share of the company.

Welcome to the brave new world of credit derivatives driven collapses. A world that is far more dangerous than the world of subprime mortgage derivatives. A complex world that because of its sheer size can potentially cause more damage in a matter of days than the subprime mortgage derivatives caused in their first year in the headlines. The chart below shows the relative size of the credit derivatives and subprime mortgage markets.

How great is the real danger? The bulk of the remainder of this article explains the extent of the danger. With a few market changes, this is the credit derivatives primer as published at numerous websites on May 2nd of 2008. There is also new material at the end of the article, talking about what could be anticipated, and introducing some solutions.

 

Read the rest at: http://www.financialsense.com/fsu/editorials/amerman/2008/0917.html

 

[Jack Black]

Is there some reason you are posting this article from MARCH 2008 now? Much of what was discussed HAS HAPPENED !! All the i-banks failed. Lehman went belly up. AIG crashed due to CDS in large part.

If you are interested in this there are hundreds of articles that are current to post & discuss.

What’s up ???

[Brad’s Gramma]

Ping!

[dennisw]

To show that back in March some people saw the CDS train wreck coming. That some were prescient

[blueplum]

I may be wrong, but I understand that CDS were a way to ‘create’ 100 or 1000 home mortgage gambling instruments from a single house mortgage. This practice led to the depression of that house’s value thru no fault of the homeowner dutifully paying their mortgage for years. IMO, CDS were and are nothing more than a well-developed conspiracy to defraud the homeowner of their hard-earned equity.

I say, declare CDS illegal gambling, herewith null and void, and hard labor prison for those that marketed them They can be joined on the road gangs and their prison tent cities with those who deliberately lied on applications to obtain loans they didn’t deserve, and the mortgage brokers who encouraged those lies, and let’s be done with this whole mess in a manner that really brings justice for the boomers or retirees who are now landlocked into homes they cannot sell, or even borrow against due to loss of that equity.

[rbg81]

Don’t all insurance work that way to some degree? For example, if 1/3 of the population died in an epidemic, Insurance companies would likely default because they didn’t plan for such a rapid, massive spate of deaths. However, the probability of that happening is miniscule, so they they take the risk. In this case, they supposedly had risk models, but things went South quicker than they figured. In short, their models weren’t worth Jack.

[Uncle Miltie]

Correct, which means all this “insurance” is worthless and the insurance companies are actually bankrupt.

Let’s get it over with, and put them in Chapter 11. Unwind the CDSs, force losses onto the suddenly uninsured, and move on.

[dennisw]

I may be wrong, but I understand that CDS were a way to ‘create’ 100 or 1000 home mortgage gambling instruments from a single house mortgage. This practice led to the depression of that house’s value thru no fault of the homeowner dutifully paying their mortgage for years. IMO, CDS were and are nothing more than a well-developed conspiracy to defraud the homeowner of their hard-earned equity.

CDS are derivatives. Derivatives are poison and we've been bailing out banks and Wall St firms that got to deep in them
Some derivatives are gambles on bundled mortgages. Dittos for credit default swaps which are sometimes used to insure these mortgage bundles

[the invisib1e hand]

Notwithstanding my post #3, there is much about CDS that needs to be explored. Their impact on the equities market, potentially creating outsize incentive to predatory short selling, is one facet.

[fella]

The medias eye view of the RAT leadership.......

[usconservative]

The trouble with Credit Default Swaps, if I understand them correctly as insurance against default, is that there is not enough financial wherewithal anywhere in the world to insure that much debt.

You understand the problem perfectly.

There's not enough money on the planet in circulation to cover the total debt to be incurred in the event of failure, and mega-hyper-inflation would ensue if the US, China, or the EU were dumb enough to TRY and print enough money to cover the debt.

There is no way to "bail out" this part of the financial market. It will FAIL as it must so the true recovery can begin.

[dennisw]

lol

[dennisw]

The trouble with Credit Default Swaps, if I understand them correctly as insurance against default, is that there is not enough financial wherewithal anywhere in the world to insure that much debt.

The insurance companies were generating insurance that they could not cover in a significant down-turn. We are there, and now the insurance companies will go belly up because they issued more insurance than they could actually back with cash.

Many recent credit default swaps were written as insurance against default of CMO (collateralized mortgage obligation which is a derivative which contains a huge bundle of mortgages or at least owes its mathematical existence to a huge bundle of mortgages)
They were written using mathematical models that assumed that house prices would never have a steep decline. These models justified the default issuer writing CDS he would never have to cover and didn't have the funds to cover. Billions in bonuses were earned writing CDS

CDS were lies and the writers knew they were lies but they were caught up in a mania just like the old tulip mania of the Dutch in 1637