While the mortgage disaster and the credit crunch keep to take their toll, there is another financial crisis building that will one day inevitably explode.
Credit-default-swaps (CDS) were developed to insure banks who gave loans against the risk of the borrower's default.
Bank-A lends 100 million to Company-C and Bank-B lends a 100 million to Company-D. Bank-A then sells Bank-B an insurance for the case of a default by Company-D and Bank-B sells Bank-A an insurance against default of Company C. Both insurances are capped at 50 million.
Now Bank-A and Bank-B have spread their default risk as each no longer depends on the performance of one big loan alone. This is a fine way for lenders to gain a bit of additional security.
But overtime financial players developed financial products that are no longer related directly to A, B, C or D. Player X believes C is more likely to default than D and player Y believes the opposite. They make a private bet with each other and document this in a not standardized contract. Such bets are derivatives of the original credit risk in that they derive their value from the performance of the original loan.
A huge problem arises when the bets on a underlying product are bigger than the original product. Imagine X and Y are betting 200 million on a negative and respectively positive performance of the 100 million loan of Company-C. X now has a huge incentive to pay 100 million or more bribe to Company-C to make it default on its loan. Y has a huge incentive to pay 100 billion or more to prevent the default of the loan Company-C got.
A derivative market that has a higher monetary value than the underlying original assets is likely to manipulate the value of the underlying assets.
William Pfaff points out that this is currently happening in the food market. People who hold billions in derivative bets on higher wheat and soybean prices are also buying the companies that stock grains. They are taking wheat off the physical market to manipulate the price upwards and to profit on their bets while elsewhere people die of hunger. Today such behavior is legal.
But back to credit default swaps. The Financial Times reports that the value of these bets have increased from $34,500 billion at the end of 2006 to $62,200 billion at the end of last year. This is more than the total outstanding credit in this world which is estimated to be some $43,000 billion.
Some start to recognize the problem:
Some credit-default indexes have morphed into what Wachovia Corp. analysts led by Glenn Schultz call "Frankenstein's monster" because they now often drive prices in the so-called cash bond market, rather than the other way around.
A house that is fire insured for multiple times of its value has a higher risk to burn than a house that is insured at less than its value. But the house insurance market is regulated and arson is a criminal act. Both prevents manipulations.
The CDS derivative market is private business with non standardized "over-the-counter" contracts that are registered nowhere but in the books of the contract partners. Nobody knows who holds what risk in these markets and how the player's bets are interrelated.
Not all of these players will play fair and when some start to manipulate the real markets the other players get screwed, go bankrupt and they whole multi-trillion system will come down.
The unwinding of these bets will have effects in the real markets through two mechanisms. Some banks and other investors will have huge losses and go out of business taking others with them. The costs for real loans will swing widely as nobody will be able to assess their real unmanipulated values. That's why Buffett calls derivatives "financial weapons of mass destruction."
Compared to what will happen in the CDS markets, the losses in subprime mortgages will look like small change.