Credit Default Swaps

When I worked at Prebon in 2000 (on financial/insurance products that would financing greenhouse gas reductions while hedging against the risk of greenhouse gas legislation), I remember trying to figure out the credit default swap market. At the time, it was a relatively new product, and it was where Prebon – a broker, not a trader – was making a killing. Generally in the financial business, new products are where all the profits are. Once your clients and competitors figure out what they’re buying, transparency comes into the market, efficiency, and prices/margins drop. But in the early days of a financial product, the margins are huge – because if you are offering something people want, and no one else is offering it, and no one else understands it, you can strip out enormous profits.

Anway, at the time the CDS market was pretty new and pretty hot. A credit default swap, nominally, is an insurance policy against the issuer of a financial product (say, a bond) defaulting. What it became was something else altogether, a massive commodity trading scheme where the underlying commodity (the CDS) had come completely uncoupled from the underlying assets. By the time things started collapsing last year, the CDS market was $30 trillion dollars. It’s a massive liability that no one’s really owned up to yet. NYTimes has a good article explaining things and asking when the next shoe will drop:

Any honest assessment must include the role that credit-default swaps have played in this mess: it’s the elephant in the room, the $30 trillion market that people do not want to talk about.

Credit-default swaps are insurancelike contracts that Wall Street created in the early 1990s. They allow bondholders to protect themselves against losses if a company or a debt issuer defaults….

Sellers of C.D.S.’s spent years raking in premiums while underestimating or simply ignoring the possibility of rising defaults. Regulators let the market grow unchecked.

In the end, far too much of this insurance was written at way too cheap a cost. Now, with Wall Street and the economy in tatters, the fear that already-hobbled financial companies may have to pay off huge amounts on C.D.S. arrangements hangs like a cloud over the markets.

C.D.S.’s have already figured prominently in taxpayer bailouts. The $150 billion rescue of the American International Group, for example, came about because of swaps the insurer had written on mortgage securities. And the $100 billion taxpayer backstop handed to Bank of America on Jan. 16 had a good bit to do with soured credit-default swaps that the bank inherited when it acquired Merrill Lynch. [more…]