CREDIT DEFAULT SWAPS

Until this year I’d never heard of a credit default swap. It’s taken some time for me to get my head around what it is and why it’s so important to what’s happening to the economy today. In essence, a CDS is like an insurance policy on methamphetamine.

Here’s a hypothetical: Mr X borrows $50 from me. I want to get insurance on his debt in case he goes broke, so I go to Miss Y and, for a premium of $4 per year, she insures the debt.

Y is betting that X will pay me back, especially since she did her homework by looking at X’s credit rating and saw it was superb. But instead of writing a standard insurance policy, Y writes me a CDS.

Unfortunately Y then has some problems with her business, and she no longer has $50 to pay me in case X goes broke. The premiums I paid her are long gone.

Credit agencies notice this and kill Y’s credit rating. Now Y is stuffed because she can no longer raise cash at good rates to keep her business open (today’s large businesses need a constant flow of credit to maintain operations). Y goes bankrupt.

Now I’m in trouble. The debt X owes me is now uninsured. The credit agencies look at my books, see I have this exposed debt, and downgrade me. I enter bankruptcy as well. But I’m knee deep in the CDS game too. I wrote a ton of them for my mate Z, insuring debts owed to him by other parties. When I go down it puts pressure on X, Y and Z. Like dominoes we fall.
In the carnage it turns out that the ratings we all used to judge each other’s debt worthiness were bogus from the start. Essentially we all just gambled like we would at a blackjack table, but we did it while drunk. And blind.

In reality, the insurance company AIG wrote $78 billion worth of CDS between 2004 and 2009. Ivy League bright boys with MBAs then turned those CDS into a device which didn’t just insure against debt, but speculated if companies would fail or not. These speculative CDS could be on-sold, and often were. So, when a company went belly-up, whoever the lucky sod was holding the CDS on it at the time made a killing.

The Toxic Asset Relief Programme (TARP) in the US, and other taxpayer funded bailouts New Zealand and other countries, meant the bright boys not only survived, they were guaranteed to make money regardless of what happened to the company. As for the poor souls who had invested in it; for most of them it was a case of, “How sad, too bad, never mind!”

Here’s the bad news: the Bank for International Settlements recently reported that total derivatives trades, including CDS, now exceeds one quadrillion dollars – that’s 1,000 trillion dollars.

How is that figure even possible? The gross domestic product of all the countries in the world is only about 60 trillion dollars.

The answer to that is the real bad news.