Saturday, September 20, 2008

The Debts of the Spenders: CDS (Credit Default Swaps) Explained

Credit default swaps (CDS) are a credit derivative. Like other derivatives, CDS are bets on future outcomes. But instead of betting on the price of orange juice or coffee, a CDS contract is a bet between two parties on whether or not a company will default on its bonds (e.g. go bankrupt).

They are called credit because they are speculating on the price of credit (bond payments). They are called default because they are speculating on whether that company will default. And finally they are called swaps because ANY 3rd party (that is major US/UK bank or insurance company) can participate. Thus a company like AIG could sell CDS to Ford to protect Ford in the case of a default. But AIG could also sell CDS to ANYONE else. Only the big boys played this game since the premium payments were so high.

In a typical CDS, the “protection buyer” gets a large payoff from the “protection seller” if the company defaults within a certain period of time, while the “protection seller” collects periodic payments from the “protection buyer” for assuming the risk of default. Just like normal insurance companies, CDS sellers collected premiums or insurance payments on a regular basis - usually every 3 months.

Unlike normal insurance, "protection buyers" were not just limited to the underlying company. Noooo. Protection sellers were willing and able to sell CDS to ANYONE with the money as long as they met regulatory standards and had the cash.

A seller like AIG could sit back and collect $320,000 a year ($80k/every 3 months) in premiums just for selling “protection” on a risky BBB junk bond from a crap company like Ford. The premiums are “free” money – free until the bond actually goes into default, when AIG could be on the hook for $100 million in claims. Remember, just like insurance the seller only charges a miniscule percentage of the total insured amount. However, they are insuring astoundingly large amounts of money here - $100 million and up. This means that only big guys can play - who else can afford to pay $80k every 3 months w/no guarantee of payment? And to do so on a scale of dozens of different CDS contracts? Not even private millionaires have the cash to participate.

And there’s the catch: what if AIG doesn’t have the $100 million? What if 10 "protection buyers" had bought CDS from AIG and now demand a total of $1 billion? AIG is screwed and goes into bankruptcy; but both parties are claiming the derivative as an asset on their books, which they now have to write down.

Players who have “hedged their bets” by betting both ways cannot collect on their winning bets; and that means they cannot afford to pay their losing bets, causing other players to also default on their bets. The result is a chain reaction that kills every major bank/insurance company in the US/UK (CDS ONLY exist in the US/UK due to "free market" principles).

Oh here's the best part - CDS aren't available to the public. They are only traded between the big boys on their own private computer networks. That means, no one - except them - knows the true price until the whole house of cards collapses.

The Federal Reserve is literally owned by a cartel of 19 banks. These are the guys who get cheap interest loans from the Fed (this is called the Fed Funds rate) and then sell it to smaller banks at higher interest. This is the ONLY reason why the Fed/Treasury acted together. They had to protect their oligopoly over dollars.


In Debt We Trust said...

UPDATE: AIG revealed this weekend that it was more than the US and UK involved in CDS trading. The list also includes continental European banks such as Deutsche Bank.