Friday, August 1, 2014

The Real Story Behind Argentina's Default: Credit Default Swaps

Jim Rickards discusses Argentina's sovereign debt default in the video below, reminding the CNBC hosts that the real problem lies not with the actual government bonds, but the insurance placed on those bonds (through credit default swaps).

While it is easy to see who will take losses on the bonds when Argentina defaults, the derivatives market exists off balance sheet in the darkness so a hedge fund or bank blowup can appear anywhere, anytime. This is what occurred during late 2008 in a much larger context when banks did not know who insured subprime debt through credit default swaps (we quickly found out the largest insurer was AIG, which then imploded).

This process will get much more exciting when Japan's government debt begins to tremble simply due to the size of their bond market and the amount of insurance that has been sold to protect against losses.

Perhaps there will be no noticeable problems in the derivatives market with the Argentina default. Or perhaps we will wake up one morning to hear about a hedge fund that is hemorrhaging cash and their positions are in liquidation. That hedge fund or bank may be insuring another set of derivatives and by shutting their doors it breaks the link in the system (like Lehman). This is the problem with the interconnected nature of the financial markets. Everyone is walking around on a mine field in the dark hoping their next step does not trigger an unseen explosion.

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