Credit Default Swaps -- What they really are and the damage they cause

[HamdenRice]

I have posted some version of this explanation of credit default swaps in several threads, but it seems that it might be useful to DUers overall to understand what these things are and how they helped bring down AIG and Lehman.

Here is a explanation combined from several posts. Sorry for the cut and paste job:

Credit default swaps (cds) are a casualty not a cause of the mortgage backed security market collapse.

But they are a big, big problem, especially for AIG and Lehman, and did play a big part in driving them to bankruptcy.

A credit default swap is an insurance policy that a bondholder buys. Borrowing the colorful names used in the Wiki article on cds, let's say that Penion Fund wants to buy bonds from Risky Corp. It buys $10 million in Risky Corp's bonds which are 7% bonds for 5 years.

Risky Corp pays 7% interest or $700,000 each year. If Pension Fund gets scared that Risky Corp will default, Pension Fund can go to AIG and ask to buy a credit default swap.

Let's say the credit default swap costs 300 basis points (that's a fancy way of saying 3%). So Pension Fund pays AID $300,000 per year out of the $700,000 per year it gets from Risky Corp.

That may sound like a lot but it means (or was supposed to mean) that there was no chance that Penion Fund could lose money. If Risky Corp sends out a letter saying, we've run out of money we're not paying interest and may not be able to pay you your $10 million in year five, under the credit default swap, Pension Fund can go to AIG and say, here's Risky Corp's bond, we want our $10 million back and AIG has to give it to them -- even if Risky Corp's bonds are now selling for $2 million on the open market because of the default.

The worst thing about credit default swaps is that the repugs put a clause in the bankruptcy code that says that credit default swaps are basically exempt from waiting in line during bankruptcy if the issuer (AIG) of the credit default swap goes into bankruptcy.

That means that while AIG's bondholders, suppliers, employees, contractors -- everyone who was owed money -- would have had to wait in line if AIG had been allowed to go bankrupt, while the bankruptcy court tried to figure out how to pay off AIG's debts, holders of credit default swaps, like Pension Fund could just go and demand payment and get it.

Credit default swaps were purchased on trillions of dollars worth of mortgage backed securities, which means that the default of mbs means that certain issuers, like Lehman, are on the lines for billions and billions -- supposedly to be paid before bankruptcy even starts.

So, yes, effectively, holders of credit default swaps can force an insurance company into bankruptcy by "jumping the line" that the bankruptcy code was supposed to create. Corporate, banking and bankruptcy law create an elaborate system of who gets what first in the case of a bankruptcy. The repugs (Gramm?) inexplicably screwed up the entire elaborate hundred year old system by putting cds first and outside of bankruptcy.

The repugs also managed to get credit default swaps exempt from regulation as insurance policies. In my example, the insurance company was paid $300,000 per year to insure Risky Corp's bond. If this had been properly regulated like other insurance policies, AIG would have been required to put that $300,000 per year (and all the other money it collected in cds fees) in other super duper safe investments, in order to save up in case they had to pay off on the policy.

Again the repugs exempted cds from insurance regulations and made sure cds were treated as a derivative commodities (go figure, I'm as puzzled as you are on that one) rather than treated as an insurance policies.

So they didn't necessarily save up the premiums. Now that institutional investors are presenting failed bonds for payment of the insurance policies, the insurance companies -- and like Lehman companies playing at being insurance companies -- don't have the cash. Hence we have bankruptcy -- but worse, because the "line" has been screwed up.

[dkf]

1. I thought Lehman had both sides of the CDS trade.

They weren't as big a problem as AIG, who decided to write a ton of these things.

[HamdenRice]

5. Yes Lehman is on both sides.

According to the ABA Journal, there is some concern that the counterparties where Lehman is insured will "walk away." Not sure how yet.

[SmokingJacket]

2. Do you know why changing these laws is not part of the bailout?

Seems like a no-brainer to regulate these things. Yet Paulson seems to want the money AND to keep the broken system.

[HamdenRice]

6. It's too late. It seems they didn't save premiums like for normal insurance

I'm not sure whether the bailout legislation could put cds in bankruptcy.

[Wilber_Stool]

3. Oh hell.

You beat me to it. Of course that didn't stop me from posting. It's early, I just got up, I couldn't see the screen, It's not my fault.

[Redbear]

4. The scariest numbers

Current amount of CDS out there: as much as $62 trillion

TOTAL WORLD GROSS DOMESTIC PRODUCT: $65 trillion

[HamdenRice]

9. Keep in mid though, that most of the insured debt isn't bad yet

As This American Life reported recently, there is $70 trillion in world savings invested in "fixed income" securities -- namely corporate and government bonds, debt, morgage backed securites, etc.

So far the cds problem is with mortgage backed securities and the bonds of financial companies.

If we can prevent the decline in confidence in the bond markets from spreading, the cds cancer will be contained. If not it will metastasize and take the entire system down.

[fishwax]

7. k/r

[coalition_unwilling]

8. K and R! - n\t

[HamdenRice]

10. Re Ben Stein article -- anyone know if cds can be "naked"?

I am under the impression that cds has to be issued to a security holder. Stein seems to be saying you can buy a cds without holding the underlying security.

That would mean buying insurance on a security you don't own, and if the security tanks, you would go out and buy it and cash it in with the insurer.

Sounds a lot like short selling.

Is that what the OpEd News piece is trying to get across?