What this article does not mention is the nature of the "real" problem with credit default swaps. Why are they ???weapons of mass destruction????
As long as they were used to cover the risk of loan defaults, then all was well. But as with many other good things, more was viewed as better.
What happened was that Credit Default Swaps were being sold to people that had not made a loan to anyone and had nothing at risk. These CDSs were based on a "reference" security. This meant that A could make a bet with B that C would default on his loan from D. These became so popular that the ???insured??? value of the CDSs exceeded the total amount actually at risk by many times. The amounts are in the trillions of dollars. There may not be enough money in the world to pay off the entire potential liability.
This practice is exactly like taking out fire insurance on your neighbor???s house. But you can only benefit if your neighbor's house burns down.
If you were an unscrupulous person and you had insured your neighbor???s house, wouldn???t you be tempted to help things along? What if you had insured a hundred houses? Would you just sit back and hope or would you attempt to improve the chances of collecting? Would you would run for local government and use your position to gut the fire department or change the building codes and then insure the new homes that were built to the lower standards.
This is exactly what has happened. The government mandated lending to people who couldn???t repay the loans. These loans became the basis for the ???reference securities??? on which people made huge bets. Every CDS that was written against a reference security was in fact a bet that that security would go into default. The government actively prevented state governments from regulating these bets or the risky loans. As a result, someone has gained trillions of dollars by draining the coffers of the organizations that sold the CDSs and then of the Federal Government.
So who are these people? Who has gained the most from the massive defaults in mortgage loans? Who were the parties that purchased these CDSs but had nothing at risk? Who was the beneficiary of the Federal Government???s gutting of the figurative ???Wall Street fire department????
AIG, the 18th largest company in the world, was given $150B of public money to keep it solvent. Most of that went to pay of CDS liabilities. This is just one company of many.
It would not surprise me one bit to discover that the people involved in setting up the scenario, that allowed CDSs and subprime mortgages to both remain unregulated, are intimately connected with the people who benefited from the firestorm that has swept through the financial system of the US and the world. Unfortunately we must rely on the shallow reporting of corporate owned news organizations to get the facts into the open.
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The Monster That Ate Wall Street
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Soon, companies like AIG weren't just insuring houses. They were also insuring the mortgages on those houses by issuing credit default swaps. By the time AIG was bailed out, it held $440 billion of credit default swaps. AIG's fatal flaw appears to have been applying traditional insurance methods to the CDS market. There is no correlation between traditional insurance events; if your neighbor gets into a car wreck, it doesn't necessarily increase your risk of getting into one. But with bonds, it's a different story: when one defaults, it starts a chain reaction that increases the risk of others going bust. Investors get skittish, worrying that the issues plaguing one big player will affect another. So they start to bail, the markets freak out and lenders pull back credit.
The problem was exacerbated by the fact that so many institutions were tethered to one another through these deals. For example, Lehman Brothers had itself made more than $700 billion worth of swaps, and many of them were backed by AIG. And when mortgage-backed securities started going bad, AIG had to make good on billions of dollars of credit default swaps. Soon it became clear it wasn't going to be able to cover its losses. And since AIG's stock was one of the components of the Dow Jones industrial average, the plunge in its share price pulled down the entire average, contributing to the panic.
The reason the federal government stepped in and bailed out AIG was that the insurer was something of a last backstop in the CDS market. While banks and hedge funds were playing both sides of the CDS business—buying and trading them and thus offsetting whatever losses they took—AIG was simply providing the swaps and holding onto them. Had it been allowed to default, everyone who'd bought a CDS contract from the company would have suffered huge losses in the value of the insurance contracts they hadpurchased, causing them their own credit problems.
Given the CDSs' role in this mess, it's likely that the federal government will start regulating them; New York state has already said it will begin doing so in January. "Sadly, they've been vilified," says Duhon, who helped get the whole thing started with that Bistro deal a decade ago. "It's like saying it's the gun's fault when someone gets shot." But just as one might want to regulate street sales of AK-47s, there's an argument to be made that credit default swaps can be dangerous in the wrong hands. "It made it a lot easier for some people to get into trouble," says Darrell Duffie, an economist at Stanford. Although he believes credit default swaps have been "dramatically misused," Duffie says he still believes they're a very effective tool and shouldn't be done away with entirely. Besides, he says, "if you outlaw them, then the financial engineers will just come up with something else that gets around the regulation." As Wall Street and Washington wring their hands over how to prevent future financial crises, we can only hope they re-read Mary Shelley's "Frankenstein."
© 2008
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