Professional Soldiers ® - View Single Post - Inventor of Credit Default Swaps is a Key Architect of Carbon Derivatives

CSB · 12-09-2009, 20:29

Ah, but again, credit default swaps sound like a good idea, and they are, if the "counterparties" are required to:

1 - Have an "insurable interest" in the default, and;

2 - Are required to bank a reserve against losses.

For those just joining in: A credit default swap is little more than me selling you a contract on the order of "If Ford Motor Company goes belly up, I'll pay you one gazillion dollars."

Well, if you are a supplier of electronic ignition systems to the Ford Motor Company, that's the kind of "insurance" you may want to invest in. After all, if Ford goes into bankruptcy, they probably aren't going to buy a lot of electronic ignition systems (or pay for the ones you have already delivered).

But if Dad, Rougish Lawyer, NMap and others also decide to go to the investment bank and buy one of those "Credit Default Swaps," they aren't investing. They are gambling. They have nothing to do with electronic ignition modules. They are just placing a bet, as if they were in a Las Vegas casino, that Ford will file for bankruptcy. But unlike a true insurance company, the bank isn't required to keep a reserve ... they can sell credit default swaps and pocket the cash until the cows come home. Then, when Ford really does file for bankruptcy, they (the investment bank) can also file for bankruptcy, unless thay have a few gazillion dollars handy to pay up every purchaser of the credit default swap.

And when -- as some investment banks did -- the bank itself buys credit default swaps in case IT has to pay off on its contracts, you end up with the situation best described by the analogy:

Interlocking credit default swaps are like mountain climbers who rope themselves together. That way, if one fall off the cliff, the others pull him back up. The problem is what happens when half of the climbers fall off the cliff. They pull the rest off the cliff, too.

And since credit default swaps are "private contracts" between businesses, they are almost totally unregulated and totally undisclosed on the company books, despite the potential for huge losses if the particular economic situation they cover turns to shit. No one knows who has secret "credit default swaps" sitting in a desk drawer somewhere, requiring the XYZ bank to pay the National Bank of Whatifkastan billions of dollars if some (God only knows) event happens (the price of oil rises, the price of oil drops, the price of oil stays the same...).

12-09-2009, 20:29	#20
CSB Quiet Professional Join Date: Feb 2004 Location: Clarksville, TN Posts: 1,164	Ah, but again, credit default swaps sound like a good idea, and they are, if the "counterparties" are required to: 1 - Have an "insurable interest" in the default, and; 2 - Are required to bank a reserve against losses. For those just joining in: A credit default swap is little more than me selling you a contract on the order of "If Ford Motor Company goes belly up, I'll pay you one gazillion dollars." Well, if you are a supplier of electronic ignition systems to the Ford Motor Company, that's the kind of "insurance" you may want to invest in. After all, if Ford goes into bankruptcy, they probably aren't going to buy a lot of electronic ignition systems (or pay for the ones you have already delivered). But if Dad, Rougish Lawyer, NMap and others also decide to go to the investment bank and buy one of those "Credit Default Swaps," they aren't investing. They are gambling. They have nothing to do with electronic ignition modules. They are just placing a bet, as if they were in a Las Vegas casino, that Ford will file for bankruptcy. But unlike a true insurance company, the bank isn't required to keep a reserve ... they can sell credit default swaps and pocket the cash until the cows come home. Then, when Ford really does file for bankruptcy, they (the investment bank) can also file for bankruptcy, unless thay have a few gazillion dollars handy to pay up every purchaser of the credit default swap. And when -- as some investment banks did -- the bank itself buys credit default swaps in case IT has to pay off on its contracts, you end up with the situation best described by the analogy: Interlocking credit default swaps are like mountain climbers who rope themselves together. That way, if one fall off the cliff, the others pull him back up. The problem is what happens when half of the climbers fall off the cliff. They pull the rest off the cliff, too. And since credit default swaps are "private contracts" between businesses, they are almost totally unregulated and totally undisclosed on the company books, despite the potential for huge losses if the particular economic situation they cover turns to shit. No one knows who has secret "credit default swaps" sitting in a desk drawer somewhere, requiring the XYZ bank to pay the National Bank of Whatifkastan billions of dollars if some (God only knows) event happens (the price of oil rises, the price of oil drops, the price of oil stays the same...).
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