The Credit Default Swap (CDS), the financial product everyone is blaming for the current U.S. financial crisis. With how they are structured, there “MAY” be some truth to it. The SPEC’s will try and explain what a CDS is and WHY they have caused so much panic & trouble.
When someone purchases a corporate bond, mortgage backed security, or any form of securitized asset (CDO), a CDS can also be purchased to “HEDGE” the purchase or (in laymen’s terms ) act as an insurance policy to make the purchaser whole in the event the company selling the asset defaults, breaks lending covenants, or files bankruptcy. Here’s the catch, or trick, and why we are in trouble:
The CDS’s can also be purchased by investors, those who don’t hold any assets, but purchase the CDS anyhow, gambling or SPECULATING that the underlying asset tied to the CDS will fail. This is similar to the OIL SPECULATORS who were blamed for running up the price of oil, but had no intention of ever taking “physical” possession of the oil purchased in the futures contracts.
Now, these products, the CDS’s are not regulated. As they were insurance products in theory, they could not “call” themselves an insurance product. If the term insurance was ever used then the company selling them would come under state regulation. That is why those Wall Street executives now testifying on Capitol Hill are telling Congress that no one knows how much of these contracts were purchased and are still outstanding. It is estimated to be at $62 trillion dollars, $62 trillion, which is more than the GDP of the United States.
Hedge Fund Manager, John Paulson, personally netted $3.7 billion last year gambling on the weaknesses in the U.S. real estate market. His company purchased real estate debt instruments and the ABX mortgage index where the investment would gain in value when these specific vehicles would decline in value, similar to purchasing PUTS. I would imagine Paulson & Company purchased a few CDS’s as well.

Why did the trouble arise? AIG (Symbol: AIG), Bear Sterns, Citigroup (Symbol: C), Lehman Brothers and other investment banks sold these Credit Default Swaps. But unlike regulated insurance products offered for sale the issuers of CDS’s did not have to have “adequate capital” in reserves to cover the losses in the event they had to pay the buyers of their CDS products (Totally opposite from that required of insurance companies).
EX: The SPEC’s, you and others form some investment partnership. We decide to purchase from AIG, the credit default swaps on the mortgage backed securities of the “subprime mortgages” issued by Bank of America’s State of Maryland portfolio (mortgages written were valued at $2 billion). Although we did not buy the specific subprime mortgage investment products, we brought the CDS’s on these products. We purchased $400,000,000 in CDS coverage and paid an annual premium to AIG in the amount of $300,000 per year. The CDS would expire in 2010 which is the date in which the mortgages in the portfolio would have to go into default or “foreclose” (No every last mortgage written, but enough where Bank of America could no longer meet its interest payments to the purchasers of the mortgage backed securities).
AIG and others, including Fannie and Freddie subsequently ran out of money. They did not have enough capital in reserve to cover the payments of the CDS products they sold. The high # of U.S. foreclosures occurred faster than anyone anticipated, including the CDS sellers. The premiums paid by the CDS purchasers did not provide enough capital to cover the payouts (Similar to homeowner insurance companies decision to no longer issue policies in areas the most susceptible to hurricane damage: Florida, Louisiana, etc..).
That is why the Treasury Department and the FED had to step in to save these firms. They were literally running out of money.
60 minutes did an excellent piece on Credit Default Swaps (CDS) this past Sunday. Take a look:
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