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credit default swaps market « Previous | |Next »
October 16, 2008

Wasn't it only Monday that global sharemarkets soared like a bird on the wing with commentators on Tuesday saying that we had stepped back from the abyss, the stockmarket had bottomed out, credit was flowing again, the storm clouds had moved on, and sunshine was on the way with Rudd's recession buster?

Now its sliding down again on fears about recession in the US, as its economy now has tremendous downward momentum. What of the unregulated $90 trillion global credit default swaps market? It seems to have been forgotten. Janet Morrissey in Time magazine says:

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.

An exciting product to make some quick and easy money during boom times. When the economy is booming, corporate defaults are few and making the swaps a low-risk way to collect premiums and earn extra cash. Initially the swaps focused primarily on municipal bonds and corporate debt in the 1990s, not on structured finance securities. Investors flocked to the swaps in the belief that big corporations would seldom go bust in such flourishing economic times.

The CDS market then expanded into structured finance, such as CDOs, that contained pools of mortgages. It also exploded into the secondary market, where speculative investors, hedge funds and others would buy and sell CDS instruments from the sidelines without having any direct relationship with the underlying investment. They are a form of "derivatives"---complex bank creations in which the basic idea is that you can insure an investment you want to go up by betting it will go down. The simplest form of derivative is a short sale: You can place a bet that some asset you own will go down, so that you are covered whichever way the asset moves.Credit default swaps are the most widely traded form of credit derivative. They are bets between two parties on whether or not a company will default on its bonds.

When the economy soured and the subprime credit crunch began expanding into other credit areas over the past year. Would the parties holding the CDS insurance after multiple trades have the financial wherewithal to pay up in the event of mass defaults? The problem is lack of regulation:

Banks and insurance companies are regulated; the credit swaps market is not. As a result, contracts can be traded — or swapped — from investor to investor without anyone overseeing the trades to ensure the buyer has the resources to cover the losses if the security defaults. The instruments can be bought and sold from both ends — the insured and the insurer.

Trouble looms as the derivatives are often three times the value of the debt they are created against.

| Posted by Gary Sauer-Thompson at 7:59 AM | | Comments (6)
Comments

Comments

As The Economist (2007-04-21) says in the article that alerted me to the dramatic rise of the CDS: "But it is in the nature of capitalism to test new ideas to destruction and to use new instruments as the basis of speculative excess." Readers of this (very pro-free market) journal have been getting warnings for years about the mess we are now in.

The following info is rephrased from the same article, with some figures expanding on your "three times the value" comment.

On any day, the notional total value of derivatives is about nine times the world GDP. The notional value of CDS paper has doubled every year since they were invented in 2000, and is currently about US$25 trillion.

Some economists look at this as an "upside-down pyramid" and inherently unstable.

Ken Davidson was talking about the same thing, and a quick google 'round indicates others also consider it the elephant in the room.
Time will tell(ulp!).
'Done Dave Bath!

Its just a facto,that overspe
nding and juggling the budget
to pay expenses which were no
y included in the rising cost
The giving of funds to bail
out companies which do not he
lp themselves and rely on bailouts,and return nothing
is not the cure.

I am a first timer here and
wrote one opinion and it can not be viewed because I wrote to many.How!!??

James,
it is the automatic spam filtering system that is cutting in. I must approve the comments.

Paul,
the problem is that it is not a static problem, in that the banks haven't suddenly come up $250 billion short. It's the dynamic problem of the deleveraging monster that only gets stronger with each institution it destroys. That $250 billion is nothing to this beast; the world's central banks have tried to provide the system with about four times that amount in recent weeks, with the money disappearing into deleveraging's black hole to emerge out the other side as Treasury bill purchases.