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Understanding Credit Default Swaps (CDS)

Posted on October 6, 2008

An understanding of credit derivatives, and specifically Credit Default Swaps (CDS), is important for comprehending the current financial crisis. An interesting paper describing the Credit Default Swap market can be found here. What is now obvious is that trillions of dollars have been siphoned off from the economy in recent years by phony CDS contracts.

The interesting part of the credit default swap market is that in many instances the amount of CDS written can, and continues to, vastly exceed the underlying credit, a completely irrational situation which can seemingly inflate the actual credit obligations in society to infinity. Of course, there is also no truly conceivable way (though bankers have of course invented ingenious ways of combating this problem) of actually honoring CDS contracts when the volume of CDS exceeds the outstanding volume of credit.

The reason for allowing this type of situation, though, was simply due to the fact that sellers/traders of CDS (like AIG) recognized some time ago that they can write CDS’s endlessly, pocket the “premiums”, and never truly set aside “reserves” to actually pay for these obligations in the event of a credit default. It’s classic insurance fraud, i.e. taking in premiums, never truly setting aside reserves, and paying huge salaries from those premiums. The situation is somewhat analogous to a life insurance company writing the same insurance policty over and over again on particular individuals, and never actually putting any money into reserves, on the assumption that people will never die. A great game until someone calls your bluff.

Some other fascinating tidbits from the paper referenced above:

“Up until 2004, the majority of credit default swaps were written on single names, but after the introduction of widely accepted credit indices in 2004 the major impetus to growth and market liquidity has been credit default swaps on indices.”

So instead of actually using CDS to limit risk on particular credits, financial institutions were essentially gambling on the credit market as a whole!

“According to the British Bankers Association, the notional amount outstanding of credit derivatives has grown from $180 billion in 1997 to over $20 trillion in 2006. Other surveys report higher numbers. ISDA, for example, began collecting CDS notional amounts in 2001, and reports growth from $632 billion in 2001 to over $34 trillion by the end of 2006; annual growth has exceeded 100 percent since mid-2004. And the Bank for International Settlements, which began collecting comprehensive statistics in 2004, reports growth of notional amount from $6.4 trillion at the end of 2004 to over $20 trillion as of June 2006 (BIS 2006).”

“The most significant change has been in the importance of hedge funds, which tend to function as both buyers and sellers: In 2000, hedge funds were 3 percent of buyers and 5 percent of sellers, but by 2006 had grown to 28 percent of buyers and 32 percent of sellers.”

With trillions upon trillions of CDS’s written by financial institutions and/or hedge funds, with no intent on paying up (and no ability to pay up), a bailout of $850 billion or a $1 trillion obviously won’t do anything. As I mentioned in the past, you can’t bail out a leverated Ponzi Scheme, as you need infinite amounts of money. Now the Fed and Treasury, have, in theory, an infinite money supply, but will printing trillions upon trillions of dollars really benefit the economy?

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