11 Oct 2008

Wipeout! Credit Defaultt Swaps enter the story

Who's heard of credit-default swaps? You will soon.

One commentator noted, "Credit-default swaps are a kind of insurance against default, arranged between two parties. One party, the seller, agrees to pay the face value of the policy in case of a default by a specific company. The buyer pays a premium, a fee, to the seller for that protection.

"This has grown to be a huge market: the total value of all CDS contracts is about $450 trillion. Some studies have put the real credit risk at just 6% of the total, or about $27 trillion. That puts the CDS market at somewhere between two and six times the size of the U.S. economy." More here.

Tom Lines has just sent me this:

One of the reasons for the further stock market panic at the end of last
week was an auction setting a price on credit default swaps (CDS's) on
Lehman Brothers' defaulted loans. It set the price at 9.75 per cent,
which - if I understand it right - means that those who issued the swaps
will have to fork out over 90 per cent of the estimated face value of
$400 billion of such paper related to Lehman's.

There have been warnings for several months of a pending catastrophe
arising from CDS - far worse than the securitised mortgage loans which
triggered the credit crisis, because it would set off a chain reaction
of further defaults, bankruptcies and crashes.

It has been reported that one reason why the US Treasury saved AIG was
that it underwrote CDS paper used by a lot of European banks as a dodge
to reduce the amount of capital they must hold. (This is explained in
the Corner House paper that Derek recommended.) Apparently if AIG had
gone under this could have spelt disaster for many leading European
banks, including Barclays and Deutsche Bank. That revelation explains
the run on European banks shortly afterwards.

According to the Bank for International Settlements, which seems to have
the only estimates of financial derivatives, there were $57.9 trillion
of CDS outstanding in Dec 2007 - twice as much as a year earlier and
four times as much as two years earlier. All were sold privately, so no
one knows this stuff for sure. It has of course never been subject to
any regulation.

You can find out more about CDS and the Lehman auction in a commentary

Best wishes,
Tom Lines

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“***** Persuasive account of how to end rural poverty” – Amazon review
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1 comment:

polizeros said...

Lehman CDS settled yesterday at less than 9 cents on the dollar. The total amount on the CDS was $400 bn. So, various entities are out $360 bn.

Nobody knows who they are or if they are lending to them. That's one reason banks aren't lending now.

WaMu CDS settle in a week or so.

Yes, it is all completely insane.