The root of the problem – CDS

October 13th, 2008 by admin | Filed under Daily News, Global Credit Crisis, Money Management, UK Bank Accounts.

A CDS or credit default swap is an instrument like an insurance contract. It allows the holder to the Credit default swap to claim money from its issuer (usually a bank) in the event that another third party defaults on its obligation to repay the money that was lent to it. It’s a kind of insurance against going out of business.

In the last few years, this market has exploded from $1tr to about $60tr as all sorts of financial institutions sought of offset risk in their dealings. So Goldman Sachs lends $10bn to Barclays bank. Goldman wants to offset the risk of Barclays going out of business. Goldman goes to AIG and asks them to write a credit default swap. AIG looks at Barclays and comes up with a premium….let’s say $50m. Then AIG, knowing that if Barclays goes out of business they’re on the hook for $10bn, offsets that risk to another issuer, let’s say, Lloyds of London.

It may even package up all its insurance policies that it’s written and asks Lloyds to insure against them all going bust…and so on and so on. The bottom line is that this type of risk was passed around and around until everyone had a little bit of it but it was unclear who exactly was the insurer of the initial risk. This is the CDS market, all be it a little simplified.

Now, here’s the bad news about this market…it is HUGE. The insured liabilities are around $60tr. That’s one year of GDP for the entire planet. Here’s the really bad news…it’s totally unregulated. The reason the banks are so hesitant to lend…the factor that is actually preventing them from lending…is this market.

This is how banks are thinking. If we can just get through this crisis, we will have a huge market share…we must survive. What do we need to do to survive? We must not run out of money or the ability to raise capital. Hence, they are hoarding capital. Even though the government is throwing money at them like a drunken sailor in a lap dancing club, they are taking it but not lending it. They don’t trust each other…they can’t figure out how big the liabilities are which are owned by other banks in the vast CDS market.

They know more high profile bankruptcies are coming and they can do little about it. It then could become like a chain reaction. Let’s say company A goes bust, Bank B is owed a $500m in a loan it made to company A. Bank B asks it’s insurer, Insurer C for the $500m for the CDS insurance policy payout. Insurer C can’t pay it or raise it and they go bust as a direct result of it. Bank B can’t pay its obligations to the people who it sold insurance to on Insurer C collapsing….then Bank B goes bust. This is the chain reaction nightmare scenario that is unfolding before the eyes of senior bankers and insurers…but they haven’t slept for days and are wide awake and terrified.