My friend A posted this and I asked his permission to repost here, because I know that while a lot of people reading this blog are in the industry, a lot of others are not and still aren’t even sure what a CDS is, or why it is that big a deal, or by what degree these contracts exceed tangible assets. Read and learn:
“The next wave of the credit crisis is happening now and it is by far the worst yet. It relates to credit default swaps which relates to counterparty risk. It may lead to the demise of our banking system as we know it. I saw this illustration and thought it was helpful:
“Say I’m company X, and I’m selling debt. You’re company Y, and you buy the debt. Understandably, you’re a little nervous that I might default, so company Z wites a CDS to cover that debt in the event of default, essentially insurance. Y buys the CDS and makes regular payments to Z for the protection. The risk is spread and everyone is happy, except Z, who’s holding the bag. So Z enters a CDS with A, A with B, B with C and so on. Now you consider that many of these transactions are practically “handshake” agreements, and there’s open speculation that even in the most benevolant of circumstances, the default of a single company, it would take years of litigation to determine the final liability.
And here’s the real kicker, there’s nothing that prevents company X from writing a CDS to protect the debt of company C. In the transitive property from your algebra class, company X can write a CDS to protect the very debt it issued in the first place”
Let me also add on top of that, there are currently $62.2 trillion dollars in contracts that insure just over $2 trillion in tangible obligations. If one bank fails you can see the domino affect falling apart as one bank owes a extensively greater amount in promised protection than the actual replacement value of the obligations. So these ‘premiums’ which need to be made are increasing, as the credit market erodes and solvency of banks are put in question.. and banks aren’t able to cover. If one goes, imagine one bank not being able to pay the other bank and the huge affect that would have and is starting to have in our financial system.”
It wouldn’t be LOLFed if I didn’t throw in this:
sophia // Sep 17, 2008 at 3:04 pm
what the heck should i do to save my 401k right now? bonds?
robert Leporatti // Sep 18, 2008 at 2:38 pm
great article, they don’t explain it on CNBC, question, what happens to company x, the seller of the debt, do they get off scott free?
alyx // Sep 19, 2008 at 11:36 am
Robert, not necessarily. For example, X may not yet have been paid in full and then the insurance could turn out to be with a counterparty that has gone bk, and there’s probably a few other potential problems in there somewhere depending on how many times the thing changed hands.