The Shell Game Known As Credit Default Swaps
Written by Bill G on September 17th, 2008 in Trainwrecks, culture, disasters.
Wall Street tumbles again after government bails out AIG, Barclays buys Lehman businesses:
Wall Street plunged again Wednesday, with anxieties about the financial system still running high after the government bailed out insurer American International Group Inc. The Dow Jones industrial average dropped about 300 points.
The two independent Wall Street investment banks left standing — Goldman Sachs Group Inc. and Morgan Stanley — remain under scrutiny, as does Washington Mutual Inc., the country’s largest thrift bank.
Gold prices surged as nervous traders sought safety. Gold jumped $86.30, or 11 percent, to $866.80 an ounce on the New York Mercantile Exchange.
A huge money-market fund, the Reserve Primary Fund, announced Tuesday that it lost money as its net asset value fell below the hallowed $1-per-share level, the first time one of these conservative funds has had a loss in 14 years.
Russian markets stopped trading for a second day after emergency funding measures by the government failed to halt the biggest stock rout since the country’s debt default and currency devaluation a decade ago.
The ruble-denominated Micex Stock Exchange suspended trading indefinitely at 12:10 p.m. after its index erased a 7.6 percent gain and plunged as much as 10 percent within an hour. The benchmark fell 17 percent yesterday, the biggest drop since Bloomberg started tracking the gauge in May 2001. The dollar- denominated RTS halted trading after similar declines.
In the simplest terms, counterparty risk is the chance that the person on the other side of a deal - the counterparty - won’t be there when it’s time to pay up.
As an insurer, AIG expanded into the business of selling insurance against bond defaults, probably figuring it wasn’t that much different than underwriting life or home insurance. AIG provided the insurance through derivative contracts known as credit default swaps. The problem for AIG is that it looks as if there could be a lot of claims at once because of a wave of defaults on mortgages and also by companies such as Lehman Brothers, Fannie Mae and Freddie Mac. By some estimates, the firm could face losses of $25-billion (U.S.) on the swaps.
How does a credit default swap work?
It’s almost like an insurance policy against a credit default - the possibility that some entity won’t make good on its debts.
With a lower credit rating, counterparties can demand that AIG put up extra collateral to ensure it can pay claims on bond defaults. AIG, according to regulatory filings, may face calls for as much as $13-billion to be set aside. That has added pressure on the company to raise money, but in today’s markets, that has proved next to impossible.
Huh? Come on… what is a CDS again?
Perhaps this graphic from the New York Times can explain it. (click for larger)
Credit Default Swaps explained - click to enlarge
Hmmm… I think I’m getting it. I think
Here’s an awesome explanation from LOLFED:
| Credit Default Swaps Explained (again) |
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The next wave of the credit crisis is happening now and it is by far the worst yet. It relates to credit default swaps which relates to counterparty risk. It may lead to the demise of our banking system as we know it. I saw this illustration and thought it was helpful:
“Say I’m company X, and I’m selling debt. You’re company Y, and you buy the debt. Understandably, you’re a little nervous that I might default, so company Z wites a CDS to cover that debt in the event of default, essentially insurance. Y buys the CDS and makes regular payments to Z for the protection. The risk is spread and everyone is happy, except Z, who’s holding the bag. So Z enters a CDS with A, A with B, B with C and so on. Now you consider that many of these transactions are practically “handshake” agreements, and there’s open speculation that even in the most benevolant of circumstances, the default of a single company, it would take years of litigation to determine the final liability. And here’s the real kicker, there’s nothing that prevents company X from writing a CDS to protect the debt of company C. In the transitive property from your algebra class, company X can write a CDS to protect the very debt it issued in the first place” Let me also add on top of that, there are currently $62.2 trillion dollars in contracts that insure just over $2 trillion in tangible obligations. If one bank fails you can see the domino affect falling apart as one bank owes a extensively greater amount in promised protection than the actual replacement value of the obligations. So these ‘premiums’ which need to be made are increasing, as the credit market erodes and solvency of banks are put in question.. and banks aren’t able to cover. If one goes, imagine one bank not being able to pay the other bank and the huge affect that would have and is starting to have in our financial system. |
Ah! So it’s a fucking shell game!
Now you finally get it.
