Punchinello’s Chronicles

November 27, 2009

What’s a Credit Default Swap – CDS

Filed under: Word of the Day — Punchinello @ 6:08 pm
Tags: , , , ,

I never really understood much about the world of finance. There are all these strange words, secret acronyms and phrases that sound like priestly incantations. It’s mostly because I’m now at the bottom of the economy that I’m curious about how all this happened, why it happened, and what will happen to the rest of the people in the workaday world. So I figured I’d use some of my free time to learn about economics and finance. One of the terms flying around everywhere is the credit-default swap, also known as the CDS.

At first I thought it was like an insurance policy. Think about when you were a kid and wanted to buy a car with a loan. You probably had to get a co-signer; someone with good and trustworthy credit, like your parents. That co-signer would vouch for you, and stand in to cover the loan if you couldn’t make the payments. Both you and the co-signer actually had a stake in the loan for the car. You, of course, wanted the car. The co-signer was placing their credibility on the line, along with their trust in your loan payment actions.

I’d thought that a CDS was a way to get something like credit-card payment insurance if you lost your job. You pay the insurance company maybe $10/month while you go out and use your credit cards. If you get sick or lose your job, then you can make a claim on the insurance and they’ll keep your payments up to date for some period of time.

Nope. It turns out that credit default swaps are legal gambling. It’s why we have the term “casino economy” floating around.

Imagine two guys on the school playground; one with a red shirt and the other a blue shirt. They’ve decided to get into a fight.

Like many situations, red-shirt and blue-shirt are pissed at each other and begin this fight. And of course people start to gather around. There’s a lot of yelling and cheering, and a crowd starts to form. Depending on where you’re from, there’s always one guy who decides to start taking bets on who will win the fight. He’s the bookie, betting agent, and also the bank.

Our bookie starts taking bets from the kids around the crowd. Ten bucks says red-shirt will win, so a kid hands the bookie $10 and gets a notation in a book. Now think about it. If red-shirt “wins” that means he’s continuing on with life. But that means blue-shirt has lost.

Now suppose that red-shirt and blue-shirt are in business. If one or the other “loses,” that could mean anything. Maybe red-shirt can’t pay a loan, or perhaps their stock goes down. It could mean they postpone a dividend or it could mean they go bankrupt. Whatever the terms of the deal, that’s the “trigger.”

So let’s offer “fight-default swaps” in the playground. I’ll “swap” you $10 for a piece of paper that says I’m “in the game.” I’ve place a bet. We’re swapping some money for a “note” otherwise known as a “security.” That note gives me the right to collect my money if I win, or lose my money if you win.

We could even make this complicated and offer “derivatives.” I give the bookie $10 to bet on the fight. In return, I get a piece of paper that says I’m “in the game.” Then I sell my piece of paper to my younger brother for $9. That way, I get at least 90% of my money. If the guy I bet on loses, my brother loses. If the bet pays off, my brother makes $1 on the deal.

And, of course, my brother could then sell another derivative to our younger sister. And so on down the line.

The ENTIRE output of the planet Earth works out to be $54-trillion. That’s the gross-domestic product (GDP) of Planet Earth. The “estimated” (i.e. wild-ass guess) of the total derivatives market is anywhere from $200-trillion to $400-trillion!

Ten bucks says that red-shirt will win the fight. Five bucks says that red-shirt may win the fight, but will end up in the hospital. On the other hand, blue-shirt is hyooooge! One dollar says that blue-shirt will lose the fight, since it’s “obvious” he’s going to beat the crap out of the other guy. Someone else doesn’t agree and says that twenty bucks says blue-shirt will lose.

Do you see how ALL these bets going on have NOTHING to do with being in a fight yourself, or the people making the bets being in the fight? They’re ALL just standing around in the crowd, watching. They have no stake whatsoever in the fight itself! If they win or lose a bet, they only win or lose money. They don’t get punched in the face!

A credit-default swap does NOT require any direct stake in the business, company or event under consideration. The bookie handling the various bets is NOT required to keep ANY of the actual money being placed for bets! None! The bookie can do whatever with the money. When the fight’s over and people want to collect their money, they just “assume” the bookie has the money.

Finally, there are no regulations whatsoever as to the process of making these bets. There are no rules, no regulations, no laws, no nothing. Anyone can start taking bets on anything.

A typical CDS bookie is a bank of some sort. They’re involved with this or that “fund,” and they look around for various things on which to place bets. It’s like any Las Vegas casino offering bets on boxing matches, horse races, soccer games or whatever. It also offers a solution to addicted gamblers. If a “legitimate” casino won’t offer odds on something weird, you can sure as hell find someone to offer odds.

You could go to Las Vegas and hear that because a lot of rain is falling in California, someone is betting $100 that 10 houses in a particular county will wash off a cliff. If you’re an addicted gambler, you’ll find someone willing to take that bet and offer odds.

So too, there is SOMEone, somewhere who’s willing to take a bet that ANY event at all, anywhere in the world is likely or unlikely to happen. And many times, the “someone” is a big bank, like Bank of America, JP Morgan, Citibank, Bank of England, or you name your favorite “too-big-to-fail” bank.

Think about our bookie in the school playground. Lots of people are handing over money, betting on blue-shirt or red-shirt. Soon, our bookie (a bank) has $1,000 in his or her pocket. Looking around, he or she sees ANOTHER fight about to break out, this time between black-shirt and yellow-shirt, somewhere else on the playground.

Our bookie truly believes that yellow-shirt is absolutely going to win that particular fight. So he or she wanders over to the other fight and finds yet another bookie taking bets. This time, our bookie (the bank) decides to bet $1,000 that yellow-shirt will win. Someone else in the crowd bets $1,000 that black-shirt will win.

What happens if the first fight comes to an end and blue-shirt loses?

Given the odds, the bookie is suddenly obligated to pay back a significant amount of money to all the kids who were placing bets in that first fight. But…unfortunately, the second fight is still going on! He or she has the $1,000 “invested” in that second fight.

A liquidity problem!

If the bookie doesn’t pay off the bets on the blue-shirt red-shirt fight, then either he or she will go bankrupt, or will get his or her kneecaps broken! Ah…but the beauty of it all is that there are NO laws that require the bookie to do squat! They just declare bankruptcy, and “someone else” (the FDIC) will pay off the bets! How sweet is THAT!

So the FDIC decides to take over the bookie’s business. Their first order of business is to sell the entire thing. To whom? Well, isn’t it lucky that the Federal Reserve has created “qualitative easement,” or QE for short. The Fed, using taxpayer money, will buy up the bookie’s business. Why?

We could let the bookie get his or her ass kicked, but they’re also the student-body president! It simply wouldn’t look good! So although the FDIC “should” put the bookie (bank) out of business, instead, they let the Federal Reserve “give” the money to cover the bets. The Fed now “owns” the bookie’s business, and hands over the $1,000 so the bookie can cover the bets.

Oddly enough, although the US Federal Reserve is now that supposed owner-of-record for the bookie’s betting business, they “actually” don’t own the business. They only have an IOU that they’ll maybe own the business. In “fact,” they let the bookie keep the business (the bank), and keep placing more bets.

The “influx of liquidity” to the “market” means that every time the bookie decides to bet on yet another fight, no matter WHAT happens, the Federal Reserve will pay off the bets! It’s like the Fed is a co-signer with unlimited money!

Credit-default can mean anything. It doesn’t actually have to mean that a company defaults on its loan payments. It doesn’t have to go broke, go into bankruptcy, become “insolvent” (has more debts than assets). In fact, a bet for or against the company can be “triggered” by anything at all. And anyone can play the game, anyone can place bets.

Better yet, the bookie taking the bets (the bank) is guaranteed to have the money to pay off those bets! That means that the bank can make more and more bets, on weirder and riskier “fights” anywhere with NO LOSS!

Nice work if you can get it!

You and I, average folks out in the world struggling to survive; we’re in “the fight.” It’s the fight to survive, to put food on the table, to pay the phone bill. We’re trying to start a business, find a job, sell something online, or whatever else it takes to keep a roof over our head.

Imagine thousands and thousands of faceless strangers, gathered around in easy chairs, munching popcorn and watching each of us (you and me). They’re laughing and joking, placing bets on our daily events. “Hey…I’ll bet that guy loses his job next week and gets thrown out on the street!”

“Ten thousand bucks says you’re wrong!”

That’s the financial markets today. That’s the so-called stock exchange, commodities markets, foreign exchange markets and so forth. That’s the “playground.” If you have the money and know-how, you too can get into the game! Bet on your neighbor losing his house! Bet on your town going broke. Or, conversely, bet on your neighbor buying a second house and selling it again for less than he thought he’d make.

It doesn’t matter. Whomever “defaults” in a credit default swap, they lose. The default is the “trigger.” Whatever the trigger is set up to be, that’s simply the bet being made. “I’ll bet that Home Depot only sells 1% more than they did last year on the day after Thanksgiving!”

You don’t have to own stock in Home Depot. You don’t have to shop there. You don’t even need to know what “Home Depot” means! All you have to do is take the bet or make the bet. If Home Depot sells 1.00001% more than they did last year at this time, then you win. If their number are down by 0.00001%, you lose.

It’s amazing, isn’t it! And you didn’t even know anyone was that interested in your life, did you!


1 Comment »

  1. […] What's a Credit Default Swap – CDS « Punchinello's Chronicles […]

    Pingback by Are You Really Watching Your Money? | the Personal Trainer’s Wife « Popular People — November 27, 2009 @ 11:58 pm | Reply

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