Credit Default Swaps

[Fern]

LINK

If President Barack Obama wants to find a scapegoat for the mess at American International Group, he needs only to look east from the White House to the halls of Congress.

AIG and the ?counterparties? it did business with are reeling because of a type of insurance policy known as a ?credit default swaps.? Though the contracts governing these exotic investments are complex, their basic idea is very simple. Sellers of these securities promise to pay any losses to a bondholder in the event a bond issuer dafaults and fails to pay back the original investment. In return the buyer pays a premium to the issuer of the policy, just as a homeowner pays a premium for fire insurance.

That?s where the similarity ends. Unlike your homeowners insurance, credit default swaps are unregulated. Investors were allowed to buy insurance on bonds they didn?t even own, and companies like AIG were allowed to write credit insurance many times over on the same bond. These bonds, many of them backed by subprime mortgages, often were rated triple-A, so no one expected them to default. Collecting premiums looked like easy money.

But when the housing market began to unwind, AIG had to begin making good on those credit default swaps. Worse, instead of just paying once, it had to pay many times over for the same defaulted bond. That became the financial equivalent of paying a dozen people for the full cost of replacing each home wiped out by a hurricane.

Because these risky bets were unregulated, none of the government agencies that were supposed to make sure the financial system was sound, from state insurance regulators to the Federal Reserve, were fully aware of just how much risk was in the system.

There were also no regulations to prevent AIG from making what Fed Chairman Ben Bernanke told CBS News Sunday were ?all kinds of unconscionable bets."

?It's absolutely unfair that taxpayer dollars are going to prop up a company that made these terrible bets, that was operating out of the sight of regulators but which we have no choice but to stabilize or else risk enormous impact, not just in the financial system but on the whole U.S. economy,? he said.

In fact, it was a law approved by Congress in 2000 that allowed companies to place tens of trillions of dollars of these risky credit default swap bets.

After the 1998 collapse of Long Term Capital Management, a giant hedge fund that pioneered the use of derivatives, the Fed engineered a rescue to prevent the unwinding of risky bets from spreading to the larger financial system. That brought calls for tighter regulation of derivatives, including a push for greater derivatives regulation at the Commodity Futures Trading Commission, led by a former Wall Street attorney named Brooksley Born.

But strong opposition to the proposal from then-Fed Chairman Alan Greenspan and senior Clinton administration officials sank the idea. On Dec. 21, 2000, President Clinton signed into law the Commodity Futures Modernization Act, which further eased restrictions on derivatives like credit default swaps.

?For at least 150 years, these sorts of gambling contracts were unenforceable if they weren?t traded on an exchange,? said Stout, the UCLA professor. ?We eliminated 150 years of insurance regulation and derivatives regulation all in the name of rocket science and financial engineering.?

The new law cleared the way for an explosion in credit default swaps. In the first half of 2001, there were $632 billion in credit default swaps outstanding, according to the International Swaps and Derivatives Association. By the second half of 2007, that number was up 100-fold ? to more than $62 trillion. Now, as the government tries to unwind the mess at AIG, much of tax money pumped into AIG has quickly flowed out to dozens of ?counterparties? ? the companies, investment funds, municipalities and others who bought credit default swaps from the insurance giant.

Credit default swaps (CDS) don't get near enough attention, IMO.

And while this 'phenomenon' grew tremendously during the Bush Admin, as shown above clearly the fault lies with the previous admin and Congress. Because they unregulated these things, no one could have known how big they had become until it exploded.

Now, how about multiple people holding insurance on bonds they don't even own? So, since these bonds have now defaulted who the heck is getting rich off their (CDS) insurance for bonds they never even owned? Where the h3ll is this money (our bailout money) going?

I've posted this for several reasons:

1. To make posters here aware of what credit default swaps are. It's a HUGE part of the problem, and again I don't think it gets enough attention (here or elsewhere)

2. I'd like to know why we should claw-back bonuses from innocent, uninvolved parties working for TARP companies, but yet these "gamblers" on CDS get their payouts for defaulted bonds they never owned. If anybody deserves to NOT get their money it's these people IMO. This is where huge amounts of our (taxpayer provided) bailout money is going. Why not claw it back from these people? "OK, sorry you've got to 'eat' your premiums paid over the years, just write if off on your taxes, but the taxpayers are NOT picking up YOUR losses from your bets on CDS's. Piss Off!".

3. Every once in a while we all get fed up. It's my turn. I'm sick and tired of reading serious financial threads here only to see the "anti-Bush freaks" spouting "your traitor-in-chief caused this economic mess..blah-blah blah...etc etc" type blather. FFS the guy did enough stupid things to be blamed for, there's no good reason to invent crap to pin on him. Such exaggeragtion just discredits legitimate critism IMO (and detracts from the quality of threads). This crap started before he took office, so lay off it. Pin it on Congress where it belongs.

4. It also serves to demonstrate how much 'leverage'was heaped upon a single thing - a home mortgage,. We start with a risk on the house loan itself, then we roll it up into a bond (MBS), then we sell insurance on the bond multiple times. One mortgage goes bad and crap echoes in the worst possible way through multiple areas.

BTW: LINK #2 CDS hammered AIG, they wrote insurance covering over $440 billion and have nowhere near enough money to cover it. I consider that a form of fraud and think they (AG) need to get on the ball investigating this and possible prosecution (Come on Obama, get moving on the real thieves/criminals and quit bashing employees and their comparatively measly millions - most of whom appear to deserve their bonuses anyway.)

Globally, there were $60 trillion in CDS outstanding by 2007. How much of that crap isn't covered? Who is gonna pay?


:music: Get your money for nothin and your chicks for free :music:


Fern

 

[sandorski]

Rolling Stone has a really good article that goes into them, but also goes into much more.

 

[frostedflakes]

This was talked about a lot back when the financial crisis really started to hit. I'd assume most people here already have at least a general idea of what credit default swaps are and their role in the subprime mess.

I'd hope Congress is working on some meaninful financial reform. Regulation of the derivatives market is long overdue.

 

[Xellos2099]

I was talking about the same thing with mortgage insurance is the problem, however peopel were saying Credit Default swap is the problem. In reality, they might not be the same, but the function is extremely similar. AIG were selling policy during the housing market boom thank to CRA act of 2000. Of course, if we had never passed CRA the mess today might not have happen but the source of the problem is with the administration. As I recall, Bush during 2004 has try to warm the congress concerning the sub prime motage but the fannie may and freddie mae say it is crazy talk.

 

[Fern]

Originally posted by: frostedflakes
This was talked about a lot back when the financial crisis really started to hit. I'd assume most people here already have at least a general idea of what credit default swaps are and their role in the subprime mess.

I'd hope Congress is working on some meaninful financial reform. Regulation of the derivatives market is long overdue.

Do you think our taxpayer bailout money should be paid to those who gambled on CDS?

Do you agree that's what we're doing?

Why is nobody talking about that?

Somebody buys insurance on a bond they don't even own, and we should cover them? These buyers aren't your average mom-and-pop types who didn't know what they were getting into. While the insurance sellers d@mn sure should have know the risk they were taking by "over-insuring' bonds, so should the buyers.

Fern

 

[GeezerMan]

I'm trying to recall what some posters in here were saying months ago about CDS not being a problem since the transactions wash themselves out.
Looks like a problem to me when they are leveraged so much. Here is a link to that Rolling Stone article mentioned. I think its excellent.
Link

 

[Genx87]

I get a vision of a devasting cascade effect with these things. Because my understanding is a bank can issue these insurances without having any real money backing it. So lets say USbank issues a bunch of CDS's and people call them in. They cant pay and default and another bank who issued CDS on USBank is now on the hook and they are stuck and it goes down the line.

This needs to be regulated and there has to be real assets to back it up.

 

[Acanthus]

CDSs are the sole reason we have to bail out financial institutions.

We are talking $50T of vaporwealth that will disappear instantly if AIG were to fold.

While i think there should be some mass lynchings, and i strongly disagree with the TARP altogether, I agree that a bailout is neccessary.

 

[Phokus]

Free Market ideology wins again.

 

[3chordcharlie]

Originally posted by: Fern

Originally posted by: frostedflakes
This was talked about a lot back when the financial crisis really started to hit. I'd assume most people here already have at least a general idea of what credit default swaps are and their role in the subprime mess.

I'd hope Congress is working on some meaninful financial reform. Regulation of the derivatives market is long overdue.

Do you think our taxpayer bailout money should be paid to those who gambled on CDS?

Do you agree that's what we're doing?

Why is nobody talking about that?

Somebody buys insurance on a bond they don't even own, and we should cover them? These buyers aren't your average mom-and-pop types who didn't know what they were getting into. While the insurance sellers d@mn sure should have know the risk they were taking by "over-insuring' bonds, so should the buyers.

Fern

The problem with CDS and whether they should be bailed out is that they are just as valid, as contracts, as any mortgage, insurance policy (or retention bonus).

The overall problem is that CDS allowed people to enter into highly risky debts with the perception of zero risk. So a situation was created where lenders didn't care about the objective risk of their lending, and yet insurers trusted lenders to be just as careful as if they were really lending their own money, which of course they effectively weren't. As an individual, why would I NOT lend you AIG's money?

Selling further CDS coverage on the side (allowing people to 'short-sell' debts they had no connection to) may have made the problem worse, but it is seperate from the fundamental disconnect between risk and lenders that it would seem drove the credit bubble.

 

[da loser]

http://forums.anandtech.com/me...d1=derivatives+buffett

 

[her209]

AIG is getting being required to put up collateral because their credit rating was lowered from AAA.

link

 

[Genx87]

Originally posted by: Phokus
Free Market ideology wins again.

This isnt a free market problem. It is a lack of govt regulation problem. A free market without regulation is anarchy. Anarchy has never produced anything but more anarchy and instability.

 

[Phokus]

Originally posted by: Genx87

Originally posted by: Phokus
Free Market ideology wins again.

This isnt a free market problem. It is a lack of govt regulation problem. A free market without regulation is anarchy. Anarchy has never produced anything but more anarchy and instability.

How can a market be "free" when it's regulated :laugh:

The only thing free market nutjobs think the government should have a hand in is enforcing contracts/protecting private property rights. That's all. To say anything else is dishonest.

 

[sandorski]

Originally posted by: Genx87

Originally posted by: Phokus
Free Market ideology wins again.

This isnt a free market problem. It is a lack of govt regulation problem. A free market without regulation is anarchy. Anarchy has never produced anything but more anarchy and instability.

"Free Market" is how deregulation was Marketed. Though I essentially agree with what you said, there's bound to be confusion on the subject.

 

[Double Trouble]

Fern, it might not be politically correct to say, but the reality is that the reason CDS's are not discussed much is that the general public is simply too stupid to understand them. If you've ever watched a "jaywalking" segment, you know what I mean.

CDS's are at the heart of the whole problem because of the way they allowed companies like AIG to leverage their assets to a dangerous level, putting everyone else in the economy on the hook for that gamble. There are two aspects that bother me about the whole CDS thing: 1) companies were allowed to purchase CDS's on assets they did not own. That basically means they were able to pay the premiums and gamble on defaults. 2) there were no real significant assets to back CDS's. Hindsight is always 20-20, but it doesn't take a rocket scientist to figure out that allowing companies to (essentially) sell default insurance without having anything to back up that insurance is a bad idea.

I hope from all this mess we get some common sense regulation of the financial system, but I'm afraid what we're going to see is just a bunch of knee-jerk over-regulation, increased unneeded government intrusion and a generally less efficient system.

 

[3chordcharlie]

Originally posted by: Double Trouble
Fern, it might not be politically correct to say, but the reality is that the reason CDS's are not discussed much is that the general public is simply too stupid to understand them. If you've ever watched a "jaywalking" segment, you know what I mean.

CDS's are at the heart of the whole problem because of the way they allowed companies like AIG to leverage their assets to a dangerous level, putting everyone else in the economy on the hook for that gamble. There are two aspects that bother me about the whole CDS thing: 1) companies were allowed to purchase CDS's on assets they did not own. That basically means they were able to pay the premiums and gamble on defaults. 2) there were no real significant assets to back CDS's. Hindsight is always 20-20, but it doesn't take a rocket scientist to figure out that allowing companies to (essentially) sell default insurance without having anything to back up that insurance is a bad idea.

I hope from all this mess we get some common sense regulation of the financial system, but I'm afraid what we're going to see is just a bunch of knee-jerk over-regulation, increased unneeded government intrusion and a generally less efficient system.

So the problem is unregulated markets, and you're afraid the response will be to regulate them.

And that's a bad thing?

*head asplodes*

 

[gingermeggs]

"stupid"
Because they do productive things in their society, other then legitimized thievery!
I want to see some heads roll, pronto!
Strip the assets and gaol those who profiteered - in any way- on this whole scene.
or better still to be hung by the neck until dead! and the assets taken of course!
if that was done it would take a generation or two for this to even happen again.

 

[bamacre]

Originally posted by: Phokus

Originally posted by: Genx87

Originally posted by: Phokus
Free Market ideology wins again.

This isnt a free market problem. It is a lack of govt regulation problem. A free market without regulation is anarchy. Anarchy has never produced anything but more anarchy and instability.

How can a market be "free" when it's regulated :laugh:

The only thing free market nutjobs think the government should have a hand in is enforcing contracts/protecting private property rights. That's all. To say anything else is dishonest.

Then why the "Free Market ideology wins again" sarcasm? Where do you think all the money came from? Do you think those "free market nutjobs" supported Greenspan and his easy money policy? Fractional Reserve banking even? Fannie and Freddie?

Those "free market nutjobs" as you say, are the ones trying to keep the banks in check. It's your government that can't handle them.

 

[jman19]

CDS contracts don't get enough attention? Have you been living under a rock?

 

[frostedflakes]

Originally posted by: jman19
CDS contracts don't get enough attention? Have you been living under a rock?

Yeah, that was my initial reaction, lol. It's been discussed to death, though, which is probably why you don't see much about them in the MSM or on the forums these days.

 

[Lemon law]

I have to thank the OP, Fern, for having an informative thread on the subject of credit default swaps. That in my humble opinion are the real cause of the financial meltdown. To some extent, we have those searching for a scapegoat to falsely point to the mortgage crisis as the root cause, and to some extent,
its true only if we consider the following analogy.

Its one thing to light a fuse, nothing will happen as the fuse burns down if its not connected to something on the other end, but something very big can happen if the other end of the fuse is connected to a barrel of gunpowder.

And in a sense, the mortgage crisis was the fuse that caused most of those 60 trillion dollars of credit default swaps to fail.

But bankers and investors can't get caught admitting they were running 60 trillion dollar gambling casino on the side backed with nothing but the illusion of credit default swaps. And betting money they did not have. The point being, these are grown men and women who invested their money, they should have seen this was a fools game, you can't create wealth out of thin air, but like Tinkerbell's pixie dust, they sure tried to believe.

Once we get that far, its easy to see what we should do. The mortgage crisis has a bottom, the 2 trillion we have already spent is more than enough to make everyone whole.

But the credit default swaps have no bottom, there is not enough money in the universe to get to the bottom, so we need to just declare ex post facto, all such credit default swap contracts null and void. To be fair to the fool who bought such a contract, they are entitled to get the original principle invested back, or the cost of the unregulated insurance policy in other words, but its not our responsibility as taxpayers to pay off every fool's bet. There are only fools on both sides of the credit default swap betting casino. Both sides should have known in advance they were betting the moon and the stars, something they did not own to start with, and its time we taxpayers tell them they must go to the moon and stars to collect their credit default swap bets.

Otherwise we buy into the Hank the Crank Paulson leave no banker or investor behind plan. Let the bankers and investors bail their own sad and sorry butts out on their own, its not our job as taxpayers. Mortgages are backed by real assets, those they bet the moon and stars bets are backed by nothing.

 

[Tom]

First of all companies like AIG are responsible for their actions, not the government. So blaming the government for their mistakes isn't right.

Secondly, many of the people who rush to blame government for a lack of oversight and regulation are the same people who want tax cuts and smaller government, which makes no sense.

 

[Phokus]

Originally posted by: bamacre

Originally posted by: Phokus

Originally posted by: Genx87

Originally posted by: Phokus
Free Market ideology wins again.

This isnt a free market problem. It is a lack of govt regulation problem. A free market without regulation is anarchy. Anarchy has never produced anything but more anarchy and instability.

How can a market be "free" when it's regulated :laugh:

The only thing free market nutjobs think the government should have a hand in is enforcing contracts/protecting private property rights. That's all. To say anything else is dishonest.

Then why the "Free Market ideology wins again" sarcasm? Where do you think all the money came from? Do you think those "free market nutjobs" supported Greenspan and his easy money policy? Fractional Reserve banking even? Fannie and Freddie?

Those "free market nutjobs" as you say, are the ones trying to keep the banks in check. It's your government that can't handle them.

Because CDS were unregulated? This has nothing to do with Greenspan and the Fed. Did you even read the OP? The explosion of CDS's happened after the deregulation. So, these assholes were 'free' to create these toxic and irresponsible insurance contracts to destroy our economy. Get it? Good.

 

[Genx87]

Originally posted by: Phokus

Originally posted by: Genx87

Originally posted by: Phokus
Free Market ideology wins again.

This isnt a free market problem. It is a lack of govt regulation problem. A free market without regulation is anarchy. Anarchy has never produced anything but more anarchy and instability.

How can a market be "free" when it's regulated :laugh:

The only thing free market nutjobs think the government should have a hand in is enforcing contracts/protecting private property rights. That's all. To say anything else is dishonest.

Do you have any idea what a "free" market is? Free markets are not anarchy which is what an unregulated market is. A 'free"market is a market that allows people to exchange goods with minimal interference but has a framework so the playing field is level and prevents abuse\fraud.