Credit Default Swaps

One of my church's longtime members, Buck Blankenship, emailed me a question about the Credit Default Swap market today, after he watched the 60 Minutes report on this "shadow market" last night. Here's the email exchange:


Subject: CDSs
Hi, Brian - thanks for the great job of explaining such a complex subject Sunday. I felt better after hearing you, but then I watched 60 Minutes and heard about the Credit Default Swaps with a market value of $60 TRILLION!! How can that be? That's larger than the stock market! And I never even heard of a Credit Default Swap! But thanks to Google, I have learned what they are and sorta how they work. I know you can't take time from your work, but if you have any "spare" time, I'd love to know:

How much of this $60 trillion is covering mortgage loans?
Will any of the $700 billion taxpayer money just approved be used to bail out owners of CDSs?
How can we put a stop to this insanity? It's giving capitalism a bad name!

bb


And, for the record, here's my reply:

Buck:

It's a huge mess. A friend of mine, Judson Russell, works at Bank of America as a derivative specialist. His job is to teach the traders on their bond desk how derivatives like Credit Default Swaps work. Chris Woolley knows him well.

After a few lunches recently with Judson, I've come to know a bit about these swaps. The 60 Minutes report just scratched the surface:


Watch CBS Videos Online

By the way, I've been a longtime subscriber to Jim Grant's newsletter (the bespectacled gentleman who leads off the piece, and who ends it with some outrage over the bank executives who let it happen).

As Judson explained it to me, these swaps have morphed over the years from instruments intended to insure against default risk into a huge, unregulated market now dominated by speculators. The "popularity" of these swaps grew so quickly over the past three years that there are now someting like 6 times the notional value of swaps ($60 trillion) as there are of the entire fixed income market ($10 trillion) they were intended to insure against.

Here's how I tried to explain it last night to Crystal as we watched 60 Minutes: Imagine your neighbor is a terrible driver, and let's say you were convinced he was going to be in a car wreck soon. You therefore decided to buy auto insurance on his car, even though you weren't the owner of the car and it wasn't your action that could lead to a crash. You merely intended to speculate on his accident. Not only that, but five other neighbors also decided to buy insurance, on the same car. You now have six insurance policies written against the same car. And the seller of that insurance is now on the hooks for six policy claims, all the result of just one accident. That is, simplistically, what the CDS market has become.

Crystal shot right back, "Why would the insurance company pay YOU (and 5 others) if it was the the neighbor's car accident?"

And that about sums up Wall Street's predicament. Crystal asked the question that every bank executive should have asked. And that, right now, is the BIG question still looming over Wall Street. Nobody thinks any of the banks and insurance companies who sold these swaps has the money to pay them off. The banks who speculated the most in this crazy market no longer trust one another, and won't lend to one another, because they don't trust each other's books.

That's the bizarre nature of this crisis. A 20% decline in house values has led to defaults in many mortgage-backed securities laden with subprime loans, which are in turn triggering an huge number of unregulated Credit Default Swaps to be "executed". One of the biggest particpants in this market was AIG, and it wiped out billions of shareholder equity before the Fed had to step in and stop it with another $85 billion, at taxpayer's expense.

The "systemic risk" you hear Paulsen and Bernanke talk about is largely the risk of a Credit Default Swap meltdown. By buying all of the bad mortgage debt with the TARP bailout fund, Paulsen and Bernanke hope to prevent a triggering default event, which would "excecute" all of these swaps and force more writedowns than the banks and the economy can bear.

As Jim Grant rightly puts it on the 60 Minutes piece, this is a fundamental breakdown of risk management on a grand scale. It is criminal that it was allowed to happen. The boards of directors and bank executives are guilty of criminal neglect here.

I encourage you to read Carl Icahn's blog, if you're interested. See: http://www.icahnreport.com/

Icahn is also outraged at how this has all come to pass, and he announced today he is organizing a United Shareholders of America movement, which seeks to reform our corporate governance laws, so that independent boards of directors can be more easily elected by shareholders. Responsibility and accountability is what is lacking at many of our banks and corporations, and Icahn wants to change that.

Regards,
Brian

On a side note, I really hope Wells Fargo prevails in the Wachovia takeover fight. Citigroup was one of the most aggressive sellers of Credit Default Swaps, and I fear they are trying to acquire Wachovia's deposit base on the cheap in order to absorb the kind of losses they know they'll have to disclose soon. Wells Fargo, on the other hand, is a very conservatively run bank, with very little in derivative exposures.