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.