Quote:
Originally Posted by Penn
Can you elaborate on the CDS market?
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I'm glad to, Chef Penn.
Let's suppose someone wishes to purchase some bonds - say, $10 million dollars worth - but they want a guarantee that the bonds will fulfill their payments. They could pay a premium - usually, a small premium - and someone, somewhere guarantees that the bond will meet its terms. It is also possible to trade the CDS, so the person making the guarantee can sell it to someone else. One problem is that no one knows who is actually obligated.
As an example, someone might have guaranteed that an XYZ bond would not default. They then found someone to trade this with, perhaps making a profit. That person (or company, more likely) did the same. This may have happened many times - say, five times. Now, if XYZ does default, a bond holder would go to the original person making the guarantee. This person would point to the next person down the line, and so forth. This works just fine if the person at the end can perform - but - what if they cannot? They refuse to pay or default. You can see the end result. It all goes to court. And if the failure is large, their may be bankruptcies all around.
Add in another problem. The CDS market was highly leveraged - as I understand it, 20 to 1. A small series of defaults results in a large, bad outcome.
Here's an example of the price action, from todays WSJ:
On Monday, many of AIG's bonds traded at levels more reflective of junk bonds that are on the verge of default. Some of the bonds traded at less than 50 cents on the dollar, having fallen from more than 80 cents last week. In the market for derivatives contracts that provide protection against debt defaults, investors were agreeing to pay $2.5 million upfront plus $500,000 annually to hedge against a default of $10 million in AIG's debt over five years, according to data provider CMA DataVision. The cost is so high because sellers of the protection want to be adequately compensated for taking on the risk.
Key point: If a bank owns an AIG bond, and wants to buy insurance, it will cost $2.5 million dollars, plus $500,000 per year to guarantee $10,000,000 in debt over 5 years.
To put this in perspective, to guarantee U.S. Treasury bonds would cost about $25,000 for $10,000,000. By the way, that's up from $21,500 on Friday. So if you had made the guarantee on Friday, you would lose $3,500 if you liquidated it today. That's volatility. Now - if you had only put up about $1,500, you would have lost all your money plus another $2,000.
LINK (Saying this another way - in this example, you would promise to pay $10,000,000 to a person buying insurance if the treasury bond defaulted. They would pay you $25,000 for doing this. If you suppose the default wouldn't happen, it's like free money. If the default does happen, there is a problem.)
AIG made a lot of these guarantees - but as overall fear in the credit markets increase, the cost to offset a guarantee goes up. Here is a link to some AIG-specific details:
LINK
This goes to the bailout or not question. Bailouts are a problem. But not bailing them out can create lots of other problems.
Another link might be of interest...
LINK