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Untangling credit default swaps

Marketplace Senior Editor Paddy Hirsch is back with the second of his Crisis Explainer videos. This time he goes to the whiteboard to make the complicated world of credit default swaps easier to understand.

Reaction has been very positive to Paddy's first lesson on collateralized debt obligations -- "Uncorking CDOs." If you haven't seen it, he'll make you an expert.

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that was absolutely fantastic. thank you

I just graduated from the University of Illinois MBA program last June and we discussed credit default swaps and the concern that a major bankruptcy could cause untold amounts exposure to these insuring firms. Since this risk was so plain to those in the finance world how is it that firms like AIG were so willing to take this risk (thus putting our entire economy at risk) and that regulators did not act (if my finance professors understood the potential damage why didn't the regulators')?

Also, isn't it true that much of this was going on through hedge funds and that they were also shorting the stocks. Everyone who held these swaps had an interest in seeing the company fail. It would be like everyone in your neighborhood taking out a million dollar life insurance policy on you. You wouldn't feel very secure.

It seems like a crime to me that these hedge funds will enrich themselves and risk our entire economy. Wouldn't it be better to let the writer of the swaps (AIG for instance) fail rather than allow them to pay out billions to non-affected entities? Perhaps it would be better to have the government guaranty to cover only AIG policy holders who have a real stake, rather than allow them to use federal dollars to enrich those who gambled on the failure of US companies.

Thanks Paddy! That presentation was brilliant!! Do you think you could do one on how Fannie Mae and Freddie Mac played such big roles in putting together the champagne bottles?

The CDO and CDS videos are very informative.

From those we got an explanation of what securities are in trouble and how CDS problems made the problem spread

Now how about explaining the short-term lending market and how credit is "frozen" and what the different actions of buying troubled assets, fixing up the mortguages, taking equity positions in banks or backing up inter-bank loans would mean.

In its current unregulated form, CDS seems to be the most convenient betting mechanism, and CDS trading desk would be the largest unregulated casino in the world.

There is an estimated 64-trillion-dollar worth of CDS contracts written. And US's national net worth is only about 53 trillion dollars. If gamblers who initiated all those CDS contracts win, which company will be standing to cover the contract losses?? Hm...

One question. How can we, or anyone, know how many times the same C D S was "insured" by how many different companies? Would this not be very similar to check kitting, as each of these could be sold and re-insured without any of the insurance companies ever knowing. This could flood the market with only a few
"bundles" of actual mortages ever existing. I feel like a good solution to this problem would be to have all the bankers figure out how much they owe to whom; strike off any over lapping indebtedness and pay their own bills.

Thanks for the explanation, very informative. One thing that I am not clear on. Since all of these credit default swaps were private OTC deal, how did the rating agencies know if companies were exposed to too much risk in order to make the determination to downgrade their credit rating? In other words, if Jim sells 'insurance' to Sam and all the other parties under private OTC deals - how does Moody's or Standard & Poor's know about all the contracts to make the decision to downgrade Jim's credit rating thereby causing him to have a margin call?

I like that you differentiate between insurance and bets. Insurance covers losses where bets yield winnings. These bets have exposed companies to huge liabilities.
The fear I have is that should any of these bets win the banks who took these bets can't pay causing the bets made on those banks to win...

If people who placed the bets can't win, because the people who took them can't pay. Then the bets have no value. As far as I can tell the bets need to be called off. To say you can't seems to say that the banks are so weak that can't survive without winning these bets. If that is the case their is no hope for them.

CDSes sound like gambling, but of a form that doesn't have to be reported. If a public company reported 'good' earnings but also had to report the level of CDSes that enabled those earnings, the market would have a much better sense of the company's real finances.

Also, surely there's going to be a lot of fraud uncovered? High finance seems ripe with it...

Randolph -
"The good part is that no matter whether
our clients make money, or lose money,
Duke & Duke get the commissions.

Mortimer -
"Well, what do you think, Valentine?"

Valentine -
"Sounds to me like you guys are a couple of bookies."

Randolph -
"I told you he'd understand."

- Trading Places

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