Saturday, September 20, 2008

Derivatives: Credit Default Swaps

Another financial article for your perusal. I am not an economist or a financial guru, so anyone in the audience with such credentials please feel free to point out any flaws that you may see.

Per wikipedia:
Derivatives are financial instruments whose value changes in response to the changes in underlying variables. The main types of derivatives are futures, forwards, options, and swaps.

Credit default swaps (CDS) are insurance-like contracts that are sold as protection against default on loans, but CDS are not ordinary insurance. Insurance companies are regulated by the government, with reserve requirements, statutory limits, and examiners routinely showing up to check the books to make sure the money is there to cover potential claims. CDS are private bets, and the Federal Reserve from the time of Alan Greenspan has insisted that regulators keep hands off.
In December 2007, the Bank for International Settlements reported derivative trades tallying in at $681 trillion – ten times the gross domestic product of all the countries in the world combined. Somebody is obviously bluffing about the money being brought to the game, and that realization has made for some very jittery markets.
CDS thus resemble insurance policies, but there is no requirement to actually hold any asset or suffer any loss, so CDS are widely used just to speculate on market changes. In one blogger's example, a hedge fund wanting to increase its profits could sit back and collect $320,000 a year in premiums just for selling "protection" on a risky BBB junk bond. The premiums are "free" money – free until the bond actually goes into default, when the hedge fund could be on the hook for $100 million in claims. And there's the catch: what if the hedge fund doesn't have the $100 million? The fund's corporate shell or limited partnership is put into bankruptcy, but that hardly helps the "protection buyers" who thought they were covered.
Now that some highly leveraged banks and hedge funds have had to lay their cards on the table and expose their worthless hands, these avid free marketers are crying out for government intervention to save them from monumental losses, while preserving the monumental gains raked in when their bluff was still good. In response to their pleas, the men behind the curtain have scrambled to devise various bailout schemes; but the schemes have been bandaids at best. To bail out a $681 trillion derivative scheme with taxpayer money is obviously impossible.
Hopefully a limited amount of regulation could fix this problem. Yesterday I heard an announcement of a moratorium on short sales to help calm the markets.

I'm not sure what to make of the author's suggestion for a solution. 'The Benjamin Franklin Solution' sounds a lot like a credit union to me. Nationalization of our banking system (or at least large portions of it) may become a reality, whether it is a good solution or not. Once again, anyone with a financial background is encouraged to shed light on this interesting subject.

See more about CDS here...

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