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Credit Default Swaps for Dummies: Part One

It pays not to stare too long at the Credit Default Swap system, in case your brain melts and your eyebrows fall off into your lap. This issue, the Occupied Times is going to dip a careful toe into the maelstrom; next issue we’ll look closer at the darker secrets and the unsettling trillion-dollar scale of the derivatives insurance market. Holding our hand through the pain will be Tony Crawford, speaker at TCU & the author of Contaging, and the broadcaster & financial commentator Max Keiser.

 

Let’s begin by looking at some of the basic terminology. Deep breath. Ready…? A Credit Default Swap or “CDS” is a contract in the credit derivatives market that transfers risk from one party to another. The risk of a default. It’s a kind of insurance – a derivative insurance contract.

 

If you’re lost already, it’s probably best to take a step back and ask: what’s a derivative…? A financial derivative is a contract, relating to an underlying asset: e.g. currencies, commodities, stocks or bonds. Let’s say, for the sake of argument, orange juice. If I  speculate on the future price of orange juice (let’s say I bet that the price of orange juice will be higher than it currently is in 6 months’ time), the value of my speculation is “derived” from the price of orange juice at a particular time in the future.

 

Derivatives ‘derive’ their value from the value of this underlying asset. Here’s where the risk comes in. Assets can lose value, markets can plummet, earthquakes can flatten power stations, companies can fail, loans can go bad, homeowners can “default” on their mortgage. And if scientists prove a link between the consumption of orange juice and the occurrence of athlete’s foot, then the value of my orange juice speculation is likely to fall through the floor.

 

Say I get nervy about the risk, maybe I want to buy a little peace of mind. Here’s where a credit default swap comes in. For a fee, the seller of the CDS underwrites or guarantees the credit-worthiness of my orange juice contract. You could describe a CDS contract as a kind of “insurance policy” against the falling value of an asset.

 

Your CDS insurance contract buys you compensation (or the promise of compensation!) – in exchange for a fee (which could be monthly, yearly, whatever the terms of the contract). The agreement is that the compensation is paid if the asset has lost value by a certain time. So if everything goes pear-shaped, the seller of the CDS – the protection seller – picks up the tab. That, at least, is the idea.

 

The CDS transfers the risk associated with a derivative without actually transferring the ownership of the underlying assets. The contract happens, as it were, ‘above’ the underpinning layer of asset-value.

 

It also happens off the balance sheets, and out of the prying eye of regulation. As the former head of the Federal Reserve, Alan Greenspan once said: “Regulation of derivatives transactions that are privately negotiated by professionals is unnecessary.”

 

TONY CRAWFORD: “A credit default swap is treated as a standard contract agreement between private parties that financiers argue need not be regulated and are too numerous for oversight.”

 

One of the main problems with the CDS system is that one agreement can lead to another can lead to another. Here’s what happens. Suppose the party that sold me my insurance against the collapse in orange juice price drinks two litres of orange juice and gets athlete’s foot. Maybe he gets nervous about the credit-worthiness of my orange juice speculation, so he goes away and approaches yet another CDS seller and enters into further “insurance” contract. This other party is free to approach yet another investor, and take out yet another insurance policy – creating what risk consultant Satyajit Das – author of Extreme Money: The Masters of the Universe and the Cult of Risk – has termed an “unholy chain”. The risk doesn’t go away, it just gets passed on. The bottom line, as Das says, is that: “if the seller of protection is unable to perform then the buyer obtains no protection.”

 

But never mind that now! Tucked away happily off the balance sheet, and joyously free from regulation, the risk gets chopped-up and passed on, with fees being picked up along the way, until a chasm has grown between the last CDS contract and the original underlying asset value (the price of orange juice). My original derivative (my speculation) has essentially vanished from sight. As has the scale of the debt (and debt-guarantees) which are floating around above the assets…

 

TONY CRAWFORD: The CDS credit derivatives market hides debt in off-the-balance-sheet accounting methods: tucked away behind misleading co-dependent loans in the complex workings of SIVs – Structured Investment Vehicles. Remember we called a CDS “a derivative insurance contract”? Maybe we were overstating the value of the guarantees that are being traded.

 

MAX KEISER: As was discovered during the AIG scandal, these so-called insurance policies should not be called insurance because they have no actual collateral backing them up, only theoretical collateral that, as we have seen, does not work in a crisis – which is exactly when the CDSs are supposed work best. In a crisis, what happens is this “unholy chain” breaks, and the Ponzi pyramid collapses.

 

MAX KEISER: Brokers and bankers who sell credit default swaps flood the market with them to garner the fees,
and in so doing increase the likelihood of a financial meltdown caused by a cascade of sell orders tied to a market swamped with uncollateralized and impossible-to-honor CDSs. We saw something similar in 1987 when the CDS product of its time – ‘portfolio insurance’ – was oversold into the market, setting up the stock market crash on October 19th of that year.

 

One way of describing the CDS problem is that it’s a problem of value. Things are being sold as having value, where in reality they have precious little. What’s “real” are the fees being charged for every breath that blows up the bubble. This bubble of swapped and re-swapped risk, floating around above the ‘real world’, has become utterly abstracted from the layer of asset-value which actually determines the value of the derivatives.

 

TONY CRAWFORD: In around 2002, financiers discovered they could sell third-party “Nonbank Notes” (essentially functioning as legal tender) that had no trace of property ownership. In such a case, purchasers are said to buy ‘naked’. However, ‘Naked’ CDS makes no financial sense except to profit from certain failure in default.

 

This is where it starts to get really nasty. If you think you’ve got your brain around the basics of credit default swaps, get ready to have your head twisted off next issue, when we’ll talk more about planned defaults, and “Naked Credit Default Swaps”, and plunge deeper still into one of the foulest corners of the global financial pit.

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