It's as easy as CDS

If AIG gets done in today or tomorrow, it won't because of the vast majority of its businesses. They're mostly doing dine. It will be because of the company’s dangerous exposure to the credit default swaps market. Here is a classic case of unintended consequences, and it's helping to strangle the financial markets. The value of the entire credit-default swaps market was just $2.19 trillion in 2002. At the end of 2007 it was $62.17 trillion. Before going any further let's have Time's Janet Morrissey explain what we’re talking about.

Credit default swaps are insurance-like contracts that promise to cover losses on certain securities in the event of a default. They typically apply to municipal bonds, corporate debt and mortgage securities and are sold by banks, hedge funds and others. The buyer of the credit default insurance pays premiums over a period of time in return for peace of mind, knowing that losses will be covered if a default happens. It's supposed to work similarly to someone taking out home insurance to protect against losses from fire and theft. Except that it doesn't. Banks and insurance companies are regulated; the credit swaps market is not. As a result, contracts can be traded — or swapped — from investor to investor without anyone overseeing the trades to ensure the buyer has the resources to cover the losses if the security defaults. The instruments can be bought and sold from both ends — the insured and the insurer.

Morrissey wrote that explainer in March - and even then AIG was in trouble. An $11 billion writedown on AIG's CDS holdings seemed like a big deal at the time; now it would look like lunch money. These CDS things became popular more than a decade ago and at the time they were seen as easy money for banks. The economy was booming and corporate defaults were rare. Another big factor: the swaps focused mostly on safer instruments like muni bonds. But then came a momentous change: the CDS market expanded into what's known as structured finance, which includes those dastardly mortgage-backed securities.

It also exploded into the secondary market, where speculative investors, hedge funds and others would buy and sell CDS instruments from the sidelines without having any direct relationship with the underlying investment. "They're betting on whether the investments will succeed or fail," said Pincus. "It's like betting on a sports event. The game is being played and you're not playing in the game, but people all over the country are betting on the outcome." But as the economy soured and the subprime credit crunch began expanding into other credit areas over the past year, CDS investors became jittery. They wondered if the parties holding the CDS insurance after multiple trades would have the financial wherewithal to pay up in the event of mass defaults.

Andrea Pincus, a partner at Reed Smith LLP, chillingly tells Morrissey: "It's the ripple effects, the domino effects" that are worrisome. "I think it's [going to be] one of the next shoes to fall." And now CDS is pretty much all the Wall Street folks are talking about. From David Gaffen at MarketBeat:

“Two years ago you’d never hear an equity trader talking about this,” says Stephen Sachs, director of trading at Rydex Investments. “Over the last 24 to 48 hours, it’s what all the stock guys are talking about: where the spreads are in the credit-default swaps market.” For Mr. Sachs, CDS are one in a long line of indicators du jour — after semiconductor chip prices, money supply data, weekly oil reserves reports, or the Treasury-to-Eurodollar spread, that will recede as the credit crisis is alleviated.

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Mark Lacter
Mark Lacter created the LA Biz Observed blog in 2006. He posted until the day before his death on Nov. 13, 2013.
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