Credit Default Swaps
Credit Default Swaps are like a car insurance. Instead of buying an insurance for a car you have bought, you buy an insurance for a Bond you bought. CDS are derivatives.
The total size of this market is A STAGGERING $ 63 Trillion !
A premium is to be paid for the risk. The higher the risk, the higher the premium. As an example - under normal circumstances, the risk for a bond issued by the American government is smaller than the risk of of bond issued by a company as General Motors.
If the risk occurs - either the interest or the Bond cannot be repaid, the damage is compensated by the Insurer.
Premiums are paid quarterly for the term of the contract but decided upon at the moment the insurance is underwritten. The higher the risk, the more expensive the premium.
Premiums for CDO's on Morgan Stanley used to be 2% ..now they are 8% to 10%
Premium for CDO's on Washington Mutual used to be 5% and spiked to 40%.
Premiums for Ford were 12% and they spiked to 18%
GM premiums rose from 10% to 25%
One of the companies which underwrote this kind of insurance (CDS) was AIG. They wrote credit default swaps on the CDO subprimes, Lehman, and other financials that went down…
Domino...domino...House of cards: One of the major mistakes the American authorities made was to let Lehman go bankrupt as this triggered the payment of huge amounts by AIG and its own default.
Credit derivatives only have 10 major players: one goes down and it affects the other 9 players (domino effect).
Credit derivative insurers cannot be compared to life insures. The reason being obvious: premiums in life insurance are calculated based on mortality tables. People tend to live an average of so many years.
Credit Default Swaps premiums are/were the result of an extremely narrow market, misallocation of funds, abnormal low interest rates and abnormal low premiums. In good times, when nothing happens, all insurers cash in the premiums and make a lot of bucks. In bad times however, the whole sector suffers and the default of one insurer can become dramatic for another insurer or financial company: if the insurer of a Bond goes bankrupt, the Bond can become insolvent and the financial company carrying it on his books follows....
BASEL II regulations define how much capital banks must maintain in reserve. Here starts the irony. This is based on the quality of the bank's loan book. Unregulated Credit Default swaps allowed banks to get around the Basel rules.
Because of a booming Real Estate market, subprime securities were insured for almost nothing. In those days, the risk of default of a mortgage was very low and if it occurred, the value of the Estate was always high enough to cover for the loss.
Ironically, the insurer (ex. AIG) did not have to put up any capital as collateral because this kind of operation is not regulated. The only condition was to maintain a triple A credit rating.
A computer model decided about the premium, and profits could be booked as soon as the swap was sold.
Under these conditions, any bank could (over) leverage itself to the full extend allowed under the Basel II regulations. The insurers could book millions of profit each year without worrying about the collateral.
But the profits which were booked never materialized and all of a sudden the default rates on mortgages multiplied and this is how certain securities labeled AAA were in fact worth less than $ 1...the end of the game!
The house of cards collapsed and what we saw was domino...domino: AIG, Lehman, Merrill Lynch, Goldman Sachs, ...a financial Tsunami!
Without the help of Government, any major bank in the World would have gone bankrupt.
Without a credit default market NO bank can report the correct state of its assets.
Without a credit default market all banks would fail the Basel II regulations.
Replacing this massive credit creating machine will lead us straight into Hyperinflation and a deep depression. No doubt about this!
The purpose for big bailouts was to prevent CDSwap explosions, risking a string of bombs to go off. The key aspect of CDSwap contracts is their hidden nature, with fuses intersecting in the dark.
The Credit Default Swaps are capable of burning Hiroshima holes all over the US financial system, resulting in US Economic implosion from eliminated bank and financial system structures almost entirely. The process has only begun, but in darkness.