A few months ago as the credit froze and the markets crashed, I said I would write about Credit Default Swaps (CDS). I was listening to National Public Radio about it here and here. They explained what CDS was and how it hurt our economy. I was appalled when I heard about it. You thought subprime mortgages were a mess, this just as bad and melting down as well. Here’s the Wikipedia definition and the Investopedia definition.
So a CDS basically was insurance that a third party entity would “insure” or “guarantee” the risk of a loan in exchange for payments from the seller of the bond. NPR defines it as you loan Ford $100, but are worried about them paying it back. So you enter into an agreement with another company to “insure” the loan at 2, 3, 4%/year in case Ford defaults.
A risk consultant Satayjit Das said it went from being insurance to being a whole different animal. Something more speculative, akin to gambling in the financial markets. Another risk consultant Gregg Berman said it became risky because you were “insuring a bond you didn’t own. Like insurance a house you didn’t own in case it burned down.”
Basically you are continually leverage loans. Apparently CDS are what brought down AIG. They were making bets on loans that eventually defaulted and had to pay out. Finally the chain broke down when one company went belly-up and that started a chain reaction of everyone owing everyone else.
These deals were completely unregulated and thus no one really knew exactly how much trouble the companies they were doing business we in. Thus the credit freeze earlier this year was because banks were nervous about lending to each other because of CDS.
This combined with bets on mortgages caused the downfall of AIG and everyone else. AIG wasn’t just insuring homes, but mortgages on the homes. As people began to default their loans came due and they couldn’t afford to pay them.
So the question arises what do we do now?
1 response so far ↓
1 Tim // Dec 9, 2008 at 4:24 pm
I’m not sure it was necessarily betting as it was wishful thinking, ignoring risk, and not determining a fair market valuation on the securities they were insuring. I really wish I could remember the article I read, I believe it was in the economist or businessweek, sometime in summer of 2007 about mortgaged backed securities and the gulf between the insured price and the actual value. the actual value being that there wasn’t a real value placed.
it was such a good article, because it foretold of the problem of these securities. the article even mentioned the fed placed valuations far below, and i mean nearly pennies on the dollar, versus what the securities were being insured for. you had huge hedge funds involved in this, which really drove these prices and valuations up.
the bottom line was, the article had stated there was going to be a huge problem if and when people called on their insurance, because the insurers could not pay the money. this is exactly what happened.
what we do now is to place the same transparency and regulatory restrictions on hedge funds as we do any other financial and banking firm. the good news in the economic mess is that hedge funds are dropping like cockroaches. second, is to ensure that proper valuations are made on securities, which was never done.
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