Credit Default Swaps and the AIG Mess
admin on March 18th, 2009
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Credit default swaps are being thrust into the limelight, most especially due to the AIG disaster and hearings going on at Capitol Hill today.
Here is a (hopefully) simple explanation of what a credit default swap is:
Borrower Bill borrows $1,000 dollars from Loaner Jim. Loaner Jim wants to obtain insurance on that debt in the event that Borrower Bill goes bankrupt. Loaner Jim goes to Insurer Ida and asks for insurance on the $1,000 loan. Ida agrees and sets a figure of $50 per year to insure that loan.
Effectively, Insurer Ida is placing a bet that Borrower Bill will make the payments back to Loaner Jim. Insurer Ida even made sure to check Borrower Bill’s credit rating and determined that it was outstanding. What happened here? Insurer Ida wrote a credit default swap, which is an unregulated derivative. This derivative was created by JP Morgan way back in 1995.
Oh, but then some problems occur with Insurer Ida’s business and she isn’t even in a position to pay Loaner Jim the $1,000 in the event that Borrower Bill goes belly-up. Now, the premiums paid have vanished. Soon thereafter, credit agencies discover the problem and tell Insurer Ida to find some new infusion of cash or her credit rating will take a hit. When Insurer Ida can’t do this, her credit rating takes a direct and devastating hit and she goes bankrupt.
Now, Loaner Jim is in big trouble. The debt which was previously insured no longer is. Loaner Jim, as a result, gets downgraded by the credit agencies. Loaner Jim is in such bad shape that he now has to declare bankruptcy. Of course, by this time, Loaner Jim has gotten in on the credit default swap action, having written countless "policies" of his own on many debts owed to his friend, Buddy Bob. When Loaner Jim’s business collapses, pressure then falls on Buddy Bob and, like a snowball rolling down a very long hill, the cumulative effect is devastating.
How is it that things unfolded this way? Well, it would appear that the ratings used to assess each other’s debt-worthiness was farcical. Everyone took a chance, a gamble, an extreme risk and the proverbial chicken is coming home to roost… and not in a good way. Not good at all.
Where does AIG fall into this equation? Well, AIG apparently wrote $78,000,000,000 worth of credit default swaps.
Oh, but it’s not just AIG. Many financial and insurance companies used these derivatives not just to insure against defaults, but to bet on whether or not other companies would fail. These swaps were used to in an effort to make money and not simply as the insurance policy as originally intended.
From the Time Magazine article on March 17th, the scope of the issue is laid out in stark detail:
The CDS market exploded over the past decade to more than $45 trillion in mid-2007, according to the International Swaps and Derivatives Association. This is roughly twice the size of the U.S. stock market (which is valued at about $22 trillion and falling) and far exceeds the $7.1 trillion mortgage market and $4.4 trillion U.S. treasuries market, notes Harvey Miller, senior partner at Weil, Gotshal & Manges. "It could be another — I hate to use the expression — nail in the coffin," said Miller, when referring to how this troubled CDS market could impact the country’s credit crisis.
It cannot be ignored that this was allowed to happen by a government run by politicians whose bank accounts were fattened with the generous donations from big bankers and insurers. They looked the other way.
A default on simply 10% of the above detailed $45,000,000,000,000 would mean certain economic disaster. Even more scary news? It’s all but certain to take place.
The scariest news of all? The Bank for International Settlements recently reported that total derivatives trades exceeded one quadrillion dollars – that’s 1,000 trillion dollars. This was made possible by the fact that these "insurance policies" are unregulated. So, the reason that all of this betting was permitted to go on was because there was nothing in place to stop them. No regulation. No oversight. No nothing. Considering that the gross domestic product of all the countries in the world is only about $60-trillion dollars, the potential for an economic disaster of epic proportions is far more likely than anyone cares to admit.
While everyone seems to have their sights set on AIG… the real culprits here are the people in Congress. Congress made back room changes back in February which allowed the bonuses to be paid by AIG (which were known and permitted by members) despite all of the debate and discussion on Capitol Hill. Now, everyone is denying responsibility, even those who are chairing the committees responsible for the changes. The denials and finger-pointing are nauseating and we can only sit back and watch our pockets continue to be picked by all of those responsible for doing what happened and worse - allowing it to happen.
