More Financial Trouble Fun Facts

Live from the inside of this crisis, I thought I’d give you another (much quicker) fun fact.

The term Credit Default Swap (CDS) refers to basically an insurance contract that’s sold as a security (like a stock or bond). It goes something like this:

Mike D lends Sander $1,000,000 at 10% for a year. Ten seconds after he does that he realizes… dang! Sander is never going to pay me back. So he calls up Ryan and asks if he’ll issue insurance at 1% of the $1,000,000 a year, so if Sander doesn’t pay then Ryan will pay mike the difference and Mike will be fine.

This in itself is a pretty good idea, it’s not all that difference from your life insurance policy. The issue comes with two things:

  • The CDS market is totaly unregulated, anyone can issue a policy with no money backing it up.
  • You can buy a CDS against something you’re not exposed to.

So if we think about insurance policies, this would be the equivalent of you being able to buy insurance on Mike D’s car. Now if the whole town buys insurance on Mike’s car, there’s a sudden benefit to something bad happening to said car. That’s why you can’t do that to start with (amongst other reasons, I’m sure.)

So what does this all mean? It means, if I’m enormous hedge fund XYZ, I will buy CDS’s against (say) Goldman Sachs while simultaneously short selling GS. That means I benefit when GS’s price drops from my short sale, as well as my insurance policy (which is worth more as GS is in more and more trouble).

Additionally, I can CAUSE the price to drop by buying these policies (as more people buy policies, their price goes up, and that makes people think GS is in trouble and drives their price down.) I can also cause price drops by massive short selling.

This is one very good theory as to why businesses that are fundamentally sound were getting beaten up, and why short selling rules have helped.

So all of this is pretty scary, especially when you realize the current value of the CDS market is 55 TRILLION dollars.

Further reading.

2 thoughts on “More Financial Trouble Fun Facts

  • 10/2/2008 at 11:16 pm

    Holy crap, that is insane.

    Going back to your example, I can see how it’d be in Mike D’s best interest to get insurance, but why would I offer it in the first place? Do CDS providers do so under the assumption that most borrowers don’t default on their loans? Is that why the system is so screwed up at the moment?

  • 10/3/2008 at 8:50 am

    It’s not unlike any other insurance… it works as long as nothing widespread and catastrophic happens. And on a no-cash-down bet you’re making money for nothing.

    Someone who works for a real insurance company could explain this better, but for every policy an insurance company holds they have a capital requirement (aka cash on hand) to cover the eventuality of an insurance claim. CDS, being unregulated, has no such requirement.

    So basically, it’s a huge scary bet… you screw up though, you go out of business (and never pay the claims… oops!)

    This is what happened to AIG, they had a ton of these swaps out on the market and as long as things went well, they made money… as the value of the CDS’s they issued fell, they were obligated (by their own contracts) to start putting up cash to cover the potential losses. That’s why AIG went from 0 to broke in a day.

    And it was a relatively small part of AIG (35 people) doing that actual trading.


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