Moon of Alabama Brecht quote
April 17, 2008

The Problem with Credit Default Swaps

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.

Posted by b on April 17, 2008 at 14:39 UTC | Permalink


That's what the Banker's Bank (Bank for International Settlements) said in their report.

Posted by: Sam | Apr 17 2008 15:33 utc | 1

Profit is impossible because the value of everything that is produced cannot be larger than the value of the consumption. In order to flee this obvious fact all sorts of intellectual frauds are committed and I mean intellectual frauds because from our earliest youth we are taught that profit is possible, and we come to believe it, and when in the course of events the inanity of profits is manifested we call that a crisis and become alarmed and see the whole superstructure of deception fall upon us .

Now we are in the throes of one of those realizations, we notice that tha sale of oil that supposedly created a profit was nothing more than the exchange of something natural into its natural result which is heat but our manner of thinking requires that we imagine the petroleun as evanescent but the coin it represented as permanent, so the coin stands for nothing and that is inflation. The situation is so dire that I will not be surprised if soon there will be rationing of gasoline and of every staple necessary for life. Derivatives, swaps, are to put it grossly, huge masturbatory financial practices, they create movement and heat but result in nothing.

Posted by: jlcg | Apr 17 2008 16:24 utc | 2

If, rather than "profit is impossible", you say
"net profit for the whole of society is impossible"
then I see your point.

But individual profit really is possible, and it really is conceived as being at someone else's expense. The deception is in viewing costs against a sustaining earth as not harming people who refuse to claim ownership of air, water, and everything else "undeveloped". The deception is in the idea that the sum total of profits is not balanced somewhere else by those profits being extracted, and inevitably impoverishing a world that relies on unowned things remaining unowned and undestroyed. The roots of the idea go back to when it was plausible to imagine rationally that the world was infinite, not limited. But the idea itself was never really rational, because it was always about desire for control.

I would translate: before the balloon is puffed up with air, and after the balloon is puffed up with air, the balloon has gained nothing, just surrounded and stunk up a lot of air.

"My air" says the balloon, "I have mixed in with it my latex!"


Thanks for clarifying how the bets are bigger than the value bet on, and making that analogy with arson/insurance scams.

I seem to recall that there are actually laws in the commercial code (tort law?) that make it possible to sue when someone else prevents you from making a profit by (more-or-less) maliciously destroying your business opportunity. I know this sort of law doesn't usually get applied to the big boys, but isn't there at least an opportunity here to declare that what the disaster-ites are doing is not only immoral, but also illegal?

Posted by: citizen | Apr 17 2008 22:08 utc | 3

Thank you for your comment.

Posted by: jlcg | Apr 17 2008 23:30 utc | 4

@b - excellent summary of CDS for the layman, thanks.

jlcg sez: "Profit is impossible because the value of everything that is produced cannot be larger than the value of the consumption." Total gibberish. Consumption, the act of using and subtracting stuff, does not create value. You can't consume that which you have not produced, unless you steal it from someone who did.


Posted by: Wolf DeVoon | Apr 18 2008 0:43 utc | 5

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 behaviour is legal.

however, its illegal in many states to buy meat for your family from the farmer down the road, unless he/she has gone through unrealistically onerous & expensive health/safety certifications.

its strange why so many communities go over-board on food-safety issues. Because the reason why we have any immunity at all is because the presence of germs (in moderation) has helped build-up our immune systems over the course of time. We may already be more immune to the germs (in the very-unfresh foods) introduced by the extensive processing/preservation/delivery methods of Big-Agro than to the germs on the local farmers hands.

Posted by: jony_b_cool | Apr 18 2008 8:25 utc | 6

Precisely my point. The consumption reveals the value of what is produced. There is value only insofar as something is desired and when it is desired it is produced. So the consumers have values that through action reveal the value of the production. So the value of the total production cannot be higher than the value given to it by consumption ergo no profit is possible.

Posted by: jlcg | Apr 18 2008 9:05 utc | 7

@Wolf excellent summary of CDS for the layman, thanks.

Thanks for the response :-) - I am never sure if these pieces are of value ...

Today's Financial Times: Investment banks eye CDS clearing house

Deutsche Bank and other investment banks are working on plans to develop a clearing house for the credit derivatives markets in an effort to allay growing regulatory and investor fears about “counterparty risk”.

In particular, the banks are tying to develop a scheme that would only allow institutions with strong capital bases and credible trading histories to clear trades in the credit default swap markets with a central counterparty.

The aim is to ensure that members of this clearing house club would be more protected from the risk of a trader or investor failing to meet their obligations.
The lightly regulated CDS market is bigger than the US government bond and housing markets combined.

However, there have been growing fears following the implosion of investment bank Bear Stearns that problems among some counterparties could wipe out trades across the market and create broader systemic risk.
The proposals to create this type of clearing house are set to be extremely controversial within the industry, not least because some bankers fear it could presage an eventual shift towards greater regulation of the CDS sector.

Some senior Wall Street figures are now warning that, if the industry does not swiftly act to tackle this counterparty risk issue via the creation of a clearing house or other mechanisms, it could be forced to accept higher regulation – or shift its activity into an exchange.

Posted by: b | Apr 18 2008 9:55 utc | 8

Thank you for your lucid explanation of CDS's.

I have been contemplating Mr. Buffet's statement about derivatives and others such as yours above. The fact is that the perpetrators of this type of trading are risking the future and lives of many millions even billions of people. If they precipitate an economic collapse, hanging would be too good for them.

This type of activity must be wound down as quickly as possible and never be allowed again.

Could the biblical Babylon that came to ruin in Revelation 18:10 be New York City and the United States? Could the ruin be the result of a derivatives inspired financial crisis? I think so and I think it is inevitable!

Posted by: jelb | Apr 18 2008 21:23 utc | 9

Washington Post business columnist Steven Pearlstein was honored with the Pulitzer Prize recently for commentary for his columns about mounting problems in the financial markets. Pearlstein was online Wednesday, April 2, at 11 a.m. ET to discuss financial regulation reform and lessons from the current crisis.

Thoiry, France: I have, in an amateur manner, tried to explain to my wife the basic principles of the $45 trillion credit defaults swaps market: Imagine that instead of going to a regulated insurance company we insure our house with a neighbor. We do this without knowing if our neighbor has sufficient funds to pay us if our house burns down. Our neighbor goes down to the local bar and (without telling us) sells the insurance contract to a stranger without making sure that he has funds to cover a fire in our house. Ten other people in the bar decide to get in on the action and sell and buy among themselves five contracts insuring our house against fire (i.e. making bets that our house will or will not burn down). In the end there are six insurance contracts on our house between people who do not know each other and who may or may not have funds to cover a fire. Imagine the mess if the house burns down...My wife does not believe that anyone would be this stupid. I claim that there are thousands of investment bankers and hedge fund managers with million dollar bonuses who are in fact this stupid. Is this correct? And what will happen when companies start to "burn down" in the coming recession?

Steven Pearlstein: You have it precisely correct. I am laughing out loud at reading your comment because I tried to do the same thing with my wife, using the same analogy, and she looked at me as if I was nuts. But it is important for everyone to understand this market, because it is a good metaphor for how we've run off the track. What started out as a legitimate hedging instrument, perhaps, has now morphed into an instrument not only of speculation but unfetterd market manipulation (SEC, please note). Moreoever, what you didn't explain to your wife is that these insurance contracts are then bought and sold on secondary markets using large amounts of debt--debt that in many cases is given by the very banks whose "house" was being insured. So you get investors who may be doubling down on their insurance bets by borrowing from the same banks, or from hedge funds that have borrowed from the same bank. That's why this is so complex, why it is so intertwined, and why nobody knows what would happen if one major institution fails, although we can surmise that the ripple effects would be significant and difficult to know in advance.

Posted by: mistah charley | Apr 19 2008 23:25 utc | 10

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