Credit default swaps have been a major element in the ongoing financial crisis. That doesn’t mean it’s necessarily easy to understand just what the problem is with them. I’ve taken a crack at it in the past, but more recently I heard an analogy that makes the entire situation a lot easier to visualize.
I heard the analogy during a radio interview with Doug Noland, a mutual fund manager who’s been writing dire weekly analyses of the credit market for years. It went something like the following.
Imagine a city near a river that is prone to the occasional flood. At some point, an enterprising citizen gets into the business of writing flood insurance, collecting premiums from insurees in exchange for a promise to pay back the insurees should a flood do any damage to their properties.
Now, imagine that there is an unusually long drought and the river goes a long time without experiencing a flood. Other enterprising types begin to notice that the flood insurer has for years been collecting all this money for doing absolutely nothing. A flood hasn’t taken place for ages — maybe climate patterns have changed so that the river doesn’t flood any more. And even if it does flood at some point, they will probably be retired by then. They want in to the easy money flood insurance game too.
Politics is the art of making
Politics is the art of making the necessary a reality. Govt or weatherman not withstanding, people need to believe they will be made whole.
I work for an organization
I work for an organization that is tired of watching friends struggle under the burden of credit card debt and unsustainable mortgage payments. This article represents a “front-end” view of the credit problem. How can we look at the “back-end” and provide effective advice to debtors on what to anticipate financially as a result of the massive changes in the economic climate for housing and credit card debt in the United States?
Raj Patel
GoalSpring
Another great article Rich.
Another great article Rich. And Doug Noland is the man. His articles can be viewed here. I read his conclusion or comments first then go back and skim the (overwhelming) data he provides in the first few pages. He knows his stuff.
http://www.prudentbear.com/
look for the credit bubble bulletin.
This American Life did a
This American Life did a segment on CDS’s, and they said that one of the biggest problems is that many of these “insurance policies” were sold to people who didn’t actually own the underlying loans.
Is that true? If so, do we know what approximately what %?
If true, it would imply several things:
(1) Someone was making heavy bets that lots of loans were going to default, even if they didn’t hold the underlying loans.
(2) The issuers were willing to take these bets…and were willing to ignore the fact that
there were so many bets on the defaults.
Who were the main purchasers of the insurance? And who was issuing this insurance?
In other words, who was betting on what?
timd wrote:
Who were the main
[quote=timd]
Who were the main purchasers of the insurance? And who was issuing this insurance?
In other words, who was betting on what?[/quote]
Nobody knows, but I’m reasonably sure most of it was hedge funds making big speculative bets on debt defaults.
I agree with jrh0 that these contracts absolutely should not be bailed out with taxpayer money. The contracts should be annulled and regulated out of existence.
Indeed, what good does it do to allow hedge funds to bet that domestic business fail? How does that encourage free enterprise?
5% of the population already controls 50% of the nations wealth. They are trying to make that 100% via exotic speculative instruments that will pay off big if we default on our mortgages, car payments and credit cards. Or the companies we work for go under. And now they want our tax dollars to backstop those bets because the counter parties that underwrote them made too many!
Let. Them. Fail.
I totally agree. Let them
I totally agree. Let them fail.
But we seem to be talking about a bunch of folks who made the *right* bets. Someone was buying massive amounts of insurance on bad loan portfolios…Which should have contributed to price discovery.
The real mystery is why the issuers of the CDSs continued to issue the insurance….And those are the folks that we should let fail.
Those who bet on defaults were right. Right?
timd wrote:I totally agree.
[quote=timd]I totally agree. Let them fail.
But we seem to be talking about a bunch of folks who made the *right* bets. Someone was buying massive amounts of insurance on bad loan portfolios…Which should have contributed to price discovery.
The real mystery is why the issuers of the CDSs continued to issue the insurance….And those are the folks that we should let fail.
Those who bet on defaults were right. Right?[/quote]
I can’t argue with this other than to say that I don’t see how swaps contribute to price discovery. If Bob bets Joe $100 that Frank is going to default on his credit card debt; how on earth does that affect the interest rate on Frank’s Visa card?
It’s just gambling, IMHO. Not only that, it gives Bob the incentive to ‘help’ Frank go into default!
The main concern I have is that bond insurers were also playing the swaps game and the more legit, regulated insurance polices are now at risk.
As an aside I’ll comment that when you hear about all the record hedge fund returns from shorting subprime RMBS’, those were all accomplished via swaps. So, basically, rich people got significantly richer betting that poor people would default on their mortgages.
Somehow I don’t see this institution as something worth saving.
As timd noted, a lot of CDSs
As timd noted, a lot of CDSs are held by persons who hold no interest in the insured property other than the CDS “bets.” I believe there’s about $55 trillion in CDSs insuring only $5 trillion in debt. Most CDS “investors” are not insuring their assets, but rather are simply placing bets that a debt issuer will default. This kind of betting, done at “bucket shops” was outlawed in the the wake of the 1907 panic, and only recently allowed again. What desirable economic function do these bets serve? We taxpayers are on the hook to pay any claims against CDSs issued by AIG. Paying such claims would only impoverish the taxpayers in order to enrich investors, most of whom have nothing at risk in a debt default. I believe the government should declare all CDSs held by investors, above an amount insuring their debt holdings, to be null and void. The CDS issuers would be obliged to return any unexpired “premium” equivalent.
Another great article that
Another great article that was concluded very nicely. I agree with Kewp. The endgame for all of this is that we MUST let all risk takers fail, plain and simple. This is the most important step for us to restore order to our flawed “free” market system.
The problem is unintended
The problem is unintended consequences.
As I’ve heard (and I’m certainly no authority) is that if you let the businesses that are at fault collapse they will bring down many more with them. We are propping them to prevent a chain reaction that could destroy our nations economic system, if not the world’s.
Morally, I’m in full agreement with most of the statements above. Practically, I don’t really want to lose my job or worse (maybe much, much worse) just to punish a few wrongdoers.
Of course, the problem with massive government intervention is that it will create other unforeseen consequences…
Those unforeseen consequences
Those unforeseen consequences can end up being a lot worse when you have a government who thinks falling home prices are the root of the problem; proof they completely misunderstand the situation.
Falling prices are a result, not a cause, of a speculative bubble caused by easy money from the Fed.
Had we raised rates early in the housing bubble, it’s likely the majority of this mess could have been averted.
Sure hindsight is 20/20, but it’s more an issue of our Government’s inability to do what is harsh, but necessary, favoring what’s easy, but temporary.
who bought cds?
Hedge funds
who bought cds?
Hedge funds bought the majority of cds. Investment banks visited clients about 5 years ago suggesting that since there weren’t enough of the underlying securities to go around (bonds) we could still ‘express a credit view’ by buying or selling CDS. (seller of cds is long risk buyer is short risk).
Problems arose as i-banks required only 3% down on cds trades and the counter party wasn’t monitored for changes in credit worthiness. Now I heard 30% down is required and that each trade has to go through a risk manager. A little late for sure.