What are Credit Default Swaps?
Unregulated Insurance Policies for Risky, Toxic Investments
Oct 19, 2008
Trading a protection policy, designed by mathematicians and physicists, purchased from a seller in order to protect the value of a financial investment, is called a Credit Default Swap (CDS). It appears to be an insurance policy purchased to protect the value of an asset; however, a swap is not regulated insurance. Law professor and former director of the Commodities Futures Trading Commission Dr. Michael Greenberger, told 60 Minutes correspondent Steve Kroft on October 5th 2008; "A credit default swap….is an insurance contract, but they've been very careful not to call it that because if it were insurance, it would be regulated. So they use a magic substitute word called a 'swap'….”
Insurance regulations require reserve capital to pay the insured. Professor of Economics and Law, Dr. William K. Black, author of the best selling book The Best Way to Rob a Bank is to Own One; said during congressional testimony on October 14th 2008 that these derivatives were “casino investing.” While “…hedging and futures trading is an integral part of financial markets…swaps have circumnavigated the regulators.”
On March 4th 2003, the BBC reported that legendary investor Warren Buffet said, “the derivatives market has exploded…with these investments to…manage market risk…” Buffet argued they “…are time bombs and financial weapons of mass destruction that could harm…the whole economic system.”
History
New to investing, the first swaps were sold in 1987 in the form of Interest Rate (IR) and Cross Currency (CC) swaps. Credit Default and Equity Swaps joined the Swap market in the first quarter of 2001 and 2002 respectively.
The total outstanding value of all IR and CC swaps was $29 trillion by 1997. The first Credit Default Swaps totaled $631 billion but by the first quarter of 2008 the 4 types of Swaps (IR, CC, Equity and Credit Default) exploded to $531.2 trillion!
Problem
The data indicates that the unregulated and under-capitalized swap market, influenced by the housing bubble, exasperated the CDS products throughout the financial and banking system.
Alan Zibel, AP business writer, reported on September 5th 2008, “a record 9% of American homeowners with a mortgage -- were either behind on their payments or in foreclosure.” Syndicated writer Peter Miller wrote on 9/23 in Realty Trac, “some 2.5 million homes are…in the ‘process of foreclosure’… the total value of such mortgages would be $440 billion.”
The Bank for International Settlements estimated the value of these swaps as $45 trillion by the end of 2008. Christopher Cox, Chairman of the SEC, testified before Congress on 9/23/08 that the national CDS market was “$58 trillion.” However, the International Swaps and Derivatives Association estimated the CDS value at $62.2 trillion at the end of 2007. Frank Partnoy, a derivatives broker and law professor argued on 60 Minutes, “It's sort of alarming that…we don't even know how big [the CDS market] is to within, say, $10 trillion."
With a value of $45 – $62 trillion the swaps are 4 times the annual GDP of the United States (13.8 trillion in 2007.) While it is agreed that the default value of these swaps is far below their notional value, the default swap ratio to the default mortgage value is still highly skewed.
Aline van Duyn wrote on October 1st in the Financial Times that in, “the credit derivatives market…because of the opacity of this market, it is still not clear how many contracts have to be settled….” Shannon Harrington wrote in Bloomberg.com, “Barclays' analysts estimated…that [if] $2 trillion in credit-default swaps…were to fail, it might trigger $57 billion in losses.” This 2.9% ratio, extrapolated over the total outstanding CDS would lead to $1.8 trillion write-off. The direct CDS losses are 4 times higher than the total value of the housing losses.
Dr. Greenberger put it best, “…there is much more…this is only the tip....”
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