The most common term you hear when they tell the country why they are bailing out these firms is that they pose systemic risk to the financial system. This is correct. If AIG was allowed to fail last week, the stock market would have collapsed in a fashion similar to the Great Depression. The reason for this collapse is not based on their subprime exposure, which I have been saying for months is just the first step of this credit crisis. It is because of their exposure to a type of derivative known as a Credit Default Swap. Back in January, I started talking about this being the next major term you would start hearing on the news. Well, it has finally hit the front page so let's talk a little bit about what it is and the risks involved.
The derivatives market is an "off balance sheet" market that has no rules and no regulations. Credit Default Swaps are one form of derivatives and probably the most popular. The CDS market is roughly $63 Trillion in size. Click on the chart below which shows the size of this market in comparison to the ENTIRE global economy and the subprime problem.
So what is a Credit Default Swap? As with everything on the Daily Tuna we're going to talk about it in very simple terms.
CDS are a form of insurance against a company defaulting. Defaulting may mean they go bankrupt or something causes them not to make their payments.
Let's say Mike wants to buy bonds in a company we'll call Bear Stearns. This means that Mike would give Bear Stearns a set amount of money and Bear Stearns pays him a fixed amount of interest on the money being lent. During the period Mike collects interest every month and at the end of the period he is paid back the total amount he lent Bear Stearns.
This works out well for Mike as long as Bear Stearns is capable of paying the interest every month and the total amount due at the end of the term. If they happen to go bankrupt, he would be wiped out. This makes him nervous so he wants to find a way to insure himself against those losses if that happens. This is just like getting insurance on your house in case it happens to get hit by a hurricane.
So he calls David and David tells him that he will insure the money that Mike lent to Bear Stearns. To insure the money he requires David to pay him 3% interest on the total amount. Again, this is just like any insurance works; car, home, ect.
The credit default swap market started fairly small in the early 2000's and has absolutely exploded in size through this year. The insurance at first was issued by a few select major banks, and then started being issued by investment banks, hedge funds, and even regular insurance companies. One of those insurance companies became a major player in the past few years. You may recognize their name as AIG.
I'll try to use another simple example to show how David would evaluate how much money he wants to insure and how much interest he needs to charge to protect himself. Let's say David insures $1,000,000,000 ($1 Billion) worth of bonds for 1,000,000,000 (1 Billion) different companies. He runs careful numbers to figure out how many of those companies will go bankrupt and how much he'd have to pay out based on that number. He assumes that in the worst case scenario .5% of the banks will fail. This means he would have to pay out $5 Million in this scenario. He then charges Mike and all the other people buying bonds 3% to insure the bonds. This means on "paper" he is making $25 Million per year. $30 Million he charges minus $5 Million against what will default and he'll have to pay out.
This scenario works fabulous as long as some event does not cause a larger than normal amount of banks to fail. An event like a subprime crisis. Every year the insurers were calculating less and less risk into their analysis. On top of this with more people entering the market there were competition for lower rates. Bank A was charging 3%, but Bank B was willing to do it for 2% so people would go with the lower rates. On top of that the people insuring the debt were paid on both the amount of bonds they insured, AND the lower they estimated the risk. Looking at the example above, if David assumed that only .25% of the banks would fail, "on paper" that year he was now making $30 Million instead of $25 Million. This meant higher and higher bonuses for these risk analysts that they collected up front.
Of course, just like with the subprime CDO's the numbers were based on home prices going up forever and there never being a recession. I don't want to make it any more confusing than what I've already talked about, but what "David" would do is look at the amount he was currently insuring and then have ANOTHER company insure his position if something should go wrong. This now creates a domino effect. If a bank fails, one insurance company cannot cover the losses and the person behind them cannot cover the losses. Remember, this market is $63 Trillion in size. It makes the subprime crisis look like a drop in the bucket.
If the government were to let a large company fail that has significant Credit Default Swap exposure, (think AIG who had $500 billion in mortgage swaps) the entire financial system would melt down. To insure this does not happen they are now putting together a plan to move all the bad debt onto the treasury's balance sheet to try to postpone this from happening. They will then print trillions of dollars to cover these losses.
The Federal Reserve knew this was coming over the summer which was why they orchestrated a major sell off in the gold and silver paper market with two of the major investment banks. These banks took short positions in July on the metals that were 5 to 10 times greater than anything ever seen before. This had the short term effect of taking down their values sharply and allowed the Fed time to orchestrate the past two weeks of bailouts. However, this short position has the effect of taking a beach ball and pushing it further and further under water.
The very rich moved into the physical metal market over the past 6 weeks and have taken enormous positions during this opportunity. In interviews with dealers around the world they will tell you they have had record buying over the past two months, but it has come in the form of multi-million dollar purchases. If you call a silver dealer today you most likely will have to wait 6-8 weeks to take physical delivery because of the current shortages. The smart money is now moving in with tremendous force because they can see what is unfolding before them.
