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Questions for the Whiteboard

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Renita Jablonski: We’ve been mentioning the Marketplace Whiteboard all week. This is our series of online videos that breaks down the terms behind the fallout of the economic crisis. Our man at the whiteboard, Senior Editor Paddy Hirsch, is with us now to answer some of the questions that have come in from listeners this week. Paddy, I’m so used to seeing you at that whiteboard, nice to have you in the studio for a change.

Paddy Hirsch: Well it’s very nice to be here, thank you.

Jablonski: One of the most popular videos is the one about credit-default swaps. And we happen to get a couple questions about this. The first one comes from Minneapolis, and this person asks: “Why offer collateral to get someone to buy insurance on investments? That doesn’t happen anywhere else.”

Hirsch: That’s absolutely right, it doesn’t happen anywhere else. Well, certainly not in our world. You know, if we’re insured in a car or a house, you don’t ask the insurance company to put up collateral, we just expect it to survive, right? In the credit-default swap world, these guys that are buying insurance, they are essentially hedging. You know, if there’s any problems in their portfolio, they want to hedge against it. And whenever they buy anything, they want to be hedged. And they might look at this person who’s selling them insurance and say, “I want to make sure that if there’s any problems with you, I’m hedged against that, and therefore I want some collateral.” And the guy who’s selling him insurance is happy about that, because he’s also buying and selling insurance himself — he’s hedging everything. So he understands that this person who is selling insurance too wants to be hedged. He also wants to be hedged, so he says OK, I’ll put up a little collateral for you, that’ll make you feel good, and you know, it’s a little bit of a sweetener to get you into my deal.

Jablonski: And then comes a company like AIG, which lost a lot of money ’cause it couldn’t live up to those commitments for credit-default swaps. That brings us to this question from a listener from Florida that says, you know, with that and the fact that AIG had backed up a lot of banks with credit-default swaps, aren’t we paying twice for the same loss?

Hirsch: Well, we should probably go back and talk about what it was that initially got AIG into trouble, and that again is this collateral issue. You know, AIG has the, had this collateral that it had put up, and it had an agreement that said if its credit rating fell, then it would have to put up more collateral — that is to say, more cash. And that’s exactly what happened — whenever Lehman Brothers went into bankruptcy, there was a systemic failure or potential systemic failure, the ratings agencies dropped the ratings on a number of financial services companies, including AIG. AIG then had to put up more money, and that was money that it didn’t have.

Jablonski: So what you’re saying is we may very well be paying more than twice.

Hirsch: Quite possibly, yeah.

Jablonski: Lots of questions we weren’t able to get to, Paddy, and we hope to have you back to do that. Senior Editor Paddy Hirsch, also known as our Whiteboard Guru. Thanks so much.

Hirsch: It’s a pleasure, thank you.

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