What's Worth TWICE as Much as the US Stock Market? Introducing "Credit Default Swaps"

[El Pinko]

http://www.nytimes.com/2008/02/17/business/17swap.html?_r=2&hp&oref=slogin&oref=slogin

Arcane Market Is Next to Face Big Credit Test

By GRETCHEN MORGENSON
Published: February 17, 2008
Few Americans have heard of credit default swaps, arcane financial instruments invented by Wall Street about a decade ago. But if the economy keeps slowing, credit default swaps, like subprime mortgages, may become a household term.

....

The market for these securities is enormous. Since 2000, it has ballooned from $900 billion to more than $45.5 trillion — roughly twice the size of the entire United States stock market.

No one knows how troubled the credit swaps market is, because, like the now-distressed market for subprime mortgage securities, it is unregulated. But because swaps have proliferated so rapidly, experts say that a hiccup in this market could set off a chain reaction of losses at financial institutions, making it even harder for borrowers to get loans that grease economic activity.

It is entirely possible that this market can withstand a big jump in corporate defaults, if it comes. But an inkling of trouble emerged in a recent report from the Office of the Comptroller of the Currency, a federal banking regulator. It warned that a significant increase in trading in swaps during the third quarter of last year “put a strain on processing systems” used by banks to handle these trades and make sure they match up.

[El Pinko]

1. kick

I know it's a dry topic, but worth learning about...

[dajoki]

2. Thanks for posting this

K&R

[ThomWV]

3. This one shot way way over my head.

This is one I simply do not understand. It seems to be a case of trying to insure the inherently un insurable, to use the transfer of risk to obliterate the identity of risk - to push the fundamentals so far into the background as to extinguish their identity; repackaging to the Nth degree. At least that is how it seems, but like I said, I can not put my finger on whatever fundamental activity these instruments were supposed to achieve.

[Yavin4]

7. It's Designed To Minimize Risk

Think of it like insurance on a bond that defaults. The risk of default gets passed around to counterparty after counterparty.

[JackRiddler]

22. No, it's designed to offer another speculative venue and it increases risk.

Do you think this market is now valuated ("bubbled" is more the word) at more than double the price of the stock exchange itself because of sober precautions against credit risk? Who's going to pay these sums on defaults? It's another exotic derivative market arising after the aggressive roll-back in the 1980s-1990s of the regulations put in place after 1929. The players hope to bluff each other out for insane sums. Instead of one company defaulting, a whole new set of chain reactions can result from defaults.

[ThomWV]

25. That is not minimization of risk, or even avoidance of risk, that is just transfer of risk

And that seems to be the point - transfer the risk again and again until it loses its identy. Sham!

[tbyg52]

15. >>to push the fundamentals so far into the background as to extinguish their identity

Yeah, and that's one of the ways we (well, "they") got into the mortgage mess, isn't it? - "securitizing" things and passing them around and around so that the original issuer felt no real sense of responsibility.....?

[Karenina]

24. Ladies and gentlemen, we have a BINGO here!

:toast:

[kineneb]

16. basic philosophy: Privatize profits, socialize risks.

reverse Robin Hood...

These exotic market entities are mostly just means for legal high-stakes gambling. They produce "wealth" for awhile by shuffling around paper, betting on the values the papers represent. In the process they have built a tall house of cards. But when one card is pulled out near the bottom (sub-prime defaults), the "confidence" of the cards is broken. Then they all fall down, because "confidence" was all that held them up. There was really nothing tangible upon which the worth was based, just air and "confidence".

That is my take, for what it is worth.

[Greyhound]

17. You got it. Very like a game of financial musical chairs.

Package 'em all up and pass 'em around and around, taking a bite at each exchange, until the music inevitably stops. Whoever is left holding the bag goes into bankruptcy and starts again. Of course it is us, the consumer-sheep that always pay the bills.

[scarletwoman]

18. Gee, a person might be tempted to call it a CONFIDENCE game! (nt)

[truedelphi]

4. If only workers had had a pension default swap plan

Set up about forty years ago, so that if your employer went into bankruptcy (taking your pension with you) you might have a way to get some percentage of your pension.

[gristy]

5. But that would benefit the workers!

It's no wonder no one came up with the idea.

[Yavin4]

8. The Government Does This Now, Correct?

If a company defaults on their pensions, the government does pay some of it.

[truedelphi]

9. Didn'thear about that. Do you have more info? n/t

[Yavin4]

11. It's Called the Pension Benefit Guaranty Corporation

http://www.pbgc.gov/

PBGC is a federal corporation created by the Employee Retirement Income Security Act of 1974. It currently protects the pensions of nearly 44 million American workers and retirees in 30,330 private single-employer and multiemployer defined benefit pension plans. PBGC receives no funds from general tax revenues. Operations are financed by insurance premiums set by Congress and paid by sponsors of defined benefit plans, investment income, assets from pension plans trusteed by PBGC, and recoveries from the companies formerly responsible for the plans.

[truedelphi]

14. Thank you. That is very good to know. n/t

[Yavin4]

6. I Just Took A Class On This

And I kept asking the question that the risk never really goes away or is minimized. It's just passed along to someone else.

[Phoebe Loosinhouse]

10. I just want to say how much I enjoy your economy related posts

Deregulation has created an economy based on smoke, mirrors, and the illusion of solvency and security. It is nothing more than a Ponzi scheme on so many levels as this post illustrates.

No, a "free market" is NOT capable of regulating itself as moronic economists, neo-cons and "small government" conservatives continue to insist. It is a license to steal and transfer wealth to the highest echelons.

The irony is that once the world's economies and currencies are so destabilized, there is not even a safe haven for the incredibly wealthy to stash their ill-gotten gains.

Just a modicum of restraint and they could have quietly kept the golden goose going for years. But no, they were too anxious to siphon off the wealth of companies and nations into their private coffers.

Everyone needs to learn that REGULATION and OVERSIGHT is NECESSARY in order to keep the game going.

I'm sure you read (if you didn't already post it) the recent great Eliot Spitzer article about how the government HAMPERS criminal investigations of economic wrongdoing.

There are truly 2 Americas - one populated by the super wealthy and one for the rest of us.Hey let's bring back the good old days before all that unnecessary regulation! Who didn't love:

child labor
no wage and hour laws
poor houses
indentured servitude
serfdom
company stores
Companies pouring their industrial wastes in rivers and streams

[JackRiddler]

12. Yes, but it's not... (as you know/belaboring the obvious)

All of these are theoretical valuations based on current market prices of daily swaps (a tiny number by comparison). If the credit actually starts to default on a large scale, the total default insurance market valuation will quickly approach a truer value of zero, no? The very idea that default insurance cumulative valuation now exceeds that of the equity markets is a tip-off that no one really believes this thing (the entire financial system) runs on anything other than hot air and faith.

And note where that line first started, at zero, in 2000 = aftermath of Glass-Steagal repeal. A Clinton achievement. Financial folly is bipartisan.

[Phoebe Loosinhouse]

13. I agree. Repealing Glass-Steagall was the real beginning

We threw out the lessons of the stock market crash and the Depression and now we'll get to relive the consequences.

[TahitiNut]

19. How is the "worth" of a CDI measured?

Is it measured against the current market value of the target security? If so, it seems as though a HUGE "short" position is being taken in the markets without the burden of ownership or much upside risk. I wonder how much is held by the issuers of those security/equity instruments. It'd be very interesting to know the aggregate annual premium payments against such "worth."

[Phoebe Loosinhouse]

20. kick! This is important stuff

We will want to reflect on all this at our catfood dinner parties in the future.

[eppur_se_muova]

21. Obsiously so much better than *working* for a living.

Chicanery brings in the $$$$ so much faster, and the taxpayers always foot the bill for the bailout.

[JackRiddler]

23. Well, not ALWAYS...

There comes the day when not even the taxpayers can cover the gap. And then - ??? - it's a new world, liable to produce revolutions and/or new tyrannies.