I’m surprised mainstream media does not talk about CDS (credit default swaps). CDSs are what crippled insurance giant AIG, and I think you will hear about this issue a lot more in the next few months… and it could get A LOT worse.
Derivatives are THE Problem
Deteriorating home values themselves aren’t to blame for the current crisis. It’s the exotic derivatives and mortgage backed secuirities financial engineers cooked up that are the problem. When you hear the talking heads on the news dropping terms like “leverage”, derivatives are what they are really referring to.
The CDS derivative market is a $62 trillion market, and is rampant with wild speculation. This is a titanic figure considering the GDP of US is $13 trillion and the US mortgage market is $7 trillion.
What are CDS
Let’s say you just bought a shiny new sports car for $100k. You can buy insurance on the car by paying an insurance company $500 a year. The insurance company promises to buy you a new sports car if you total your car.
The insurance is like a CDS, except CDSs insure corporate bonds in the event that a corporation goes bust.
However, with a CDS, you can buy insurance even if you don’t own the bond; this is called speculation. When you buy a CDS w/o owning the underlying bond, you are essentially betting that the corporation will go bankrupt. This is like buying car insurance for your friends shiny new Ferrari, hoping to collect in the event that he crashes. Some hedge funds even allegedly speculate in CDS while sabotaging their underlying corporate stocks to increase the chances of bankruptcy. This is the equivalent of cutting the brakes on your friend’s Ferrari.
The Problem with CDS
Uncontrolled greed and lack of regulation has allowed banks and other financial institutions to insure more corporate bonds than they can afford. There is no authority in the CDS market that ensures that people who are writing insurance can actually cover it in the event of a disaster. Another problem is that these policies can be bought, sold, and traded like stocks. Even if a sound, well capitalized institute originated the CDS, they could have sold the contract to a non-so-sound company that can’t cover the cost of default. This is truly a ticking time bomb.
If a behemoth nationwide bank fails, company X, which has written far too many CDS contracts, will have to pay billions or trillions to cover the insurance. There is no company on the planet that has that much money, so company X would have to declare bankruptcy too. Whoever wrote CDSs for company X would have to cough up insurance money (that it doesn’t have), setting off a domino of bankruptcies.
This is a lot like mortgage backed securities. Banks kept lending money, expecting that housing prices would never fall. Analogously, insurers kept writing CDS contracts to investors and speculators, never expecting that a behemoth corporation like Lehman or Bear Stearns could ever go bust.
This is why you see the Fed stepping in to save companies like AIG. One failure will inevitably lead to another. Because of CDS, some companies really are “too big to fail.”