The Financial Tsunami that is around the corner – Credit Default Swaps

Here are some sizes in US dollars of the various markets and the US budget.  Make sure you realize the size and the comparison I am going to now make.

– United States federal budget, 2009 – $3.10 trillion
– Aggregate size of US real estate market in 2000 = $4.4 trillion
– Total Market Capitalization of all companies in the world = $51 Trillion

You have probably not heard about it.  The mechanism is called Credit Default Swap.  This is the wikipedia definition:

A credit default swap (CDS) is an instrument to transfer the credit risk of fixed income products. Using technical terms, it is a bilateral contract, in which two counterparties agree to isolate and separately trade the credit risk of at least one third-party reference entity. The buyer of a credit swap receives credit protection. The seller ‘guarantees’ the credit worthiness of the product. In more technical language, a protection buyer pays a periodic fee to a protection seller in exchange for a contingent payment by the seller upon a credit event (such as a default or failure to pay) happening in the reference entity. When a credit event is triggered, the protection seller either takes delivery of the defaulted bond for the par value (physical settlement) or pays the protection buyer the difference between the par value and recovery value of the bond (cash settlement). Simply, the risk of default is transferred from the holder of the fixed income security to the seller of the swap. For example, a mortgage bank, ABC may have its credit default swaps currently trading at 265 basis points (bp). In other words, the annual cost to insure 10 million euros of its debt would be 265,000 euros. If the same CDS had been trading at 7 bp a year before, it would indicate that markets now view ABC as facing a greater risk of default on its mortgage obligations.

So, inherently it acts as an insurance as the debt owners use it to hedge against the credit default.  But the instruments have been used in speculative transactions with hedge funds and other market speculators.

The worst is that the instruments that were sold (and bought!) were done with very complicated mathematical models that were not perfect.  Traders used these imperfect models to do more and more trades.  So instead of selling the exposures to credit just once (the underlying asset), it was sold 10 times or even 20 times by the banks.  So, when the underlying loans are defaulted, that default will be multiplied manifold.

If this was a figure that could be handled, then it would have been easy to brush this away.  But (now look at the figures at the beginning of this article again) the entire size of this Credit Default Swap market is USD 50 trillion!  That’s the ENTIRE MARKET CAPITALIZATION OF ALL COMPANIES IN THE WORLD together!!

Do you see the magnitude of the Tsunami waiting for the world?

Why did this happen?

Allen Greenspan and the rest of the smart economists knew about these fuzzy instruments but they used to praise them.  As late May of 2005, Greenspan was eulogizing the tremendous RISK MANAGEMENT features of these instruments and how this market may have reached a notional mark of USD 220 Trillion!  (Fed Statement)

Here is a question to him and his answer in September of 2007.

Q: Well, credit derivatives, esoteric.

A: Well, credit derivatives I think are an extraordinarily valuable thing. What they do is they move the credit from the initiator of the loans, which are highly leveraged financial institutions. They put the credit risk, sell the credit risk, to those with very less leverage and capable of absorbing losses. That’s had a very positive effect on the international financial systems, had a very positive effect on American banking.

Interest rate derivatives, foreign exchange derivatives have been very valuable in shifting risks around in an appropriate manner. We have not had a failed major institution in a very long period of time.

And one of the reasons is they’ve been able to pass off risks that in past generations they would have had to have and run into a very significant financial problem.

So I think financial intervention has been extraordinary. What you have to be careful about is collateral debt obligations which have gotten much too sophisticated, are priced by extraordinary mathematical models, and they are very difficult to value.

And what we have found is we have left this to credit rating agencies and what they designated as the so-called Triple-A tranches of a lot of these vehicles, turned out to be selling as though they were Double-B’s.

And I think we’re going to find that there’s going to be no regulation, but a lot of the collateral debt obligations, collateral loan obligations, these special investment vehicles, all of which are highly questionable, I think people are going to be frightened to deal with those things for a long time, and many instances, a lot of them, are just going to disappear because they’ve been tried. They don’t work.

But the big derivative markets continue to increase at a very rapid rate, and the reason is that they are important instruments for risk dispersion throughout the world.

So, how was an instrument that was meant to distribute risks around, going to become the greatest villain that modern financial markets may have ever seen?

Instead of this being bought and sold on need and requirement to spread risk around for specific banks and financial institutions, these very instruments became the favorite game after Russian Roulette in the world’s financial districts.  Many dubious hedge funds were buying these in a speculative mode.

Result: What was meant to spread risk, ended up creating several times more than the underlying asset!