3.19.2009

Credit Default Swaps: My Most Boring Post Ever?

"Lawmakers continued to fume over the $165 million in retention bonuses to employees at AIG's financial products division, the unit that created the credit-default swaps and other financial derivatives that brought AIG to the brink of bankruptcy in September."


I think I understand a credit default swap. Maybe. Here goes: Say you loan a friend $10,000 for one year at 10% interest. If all goes well, you will make $1,000 profit. But what if you are a little nervous that your buddy won't pay you back? What if you could find someone to insure the loan for, say, 2% of the return. So you find a guy who promises to pay you the $11,000 if your buddy fails to and for that guarantee you'll pay that guy $200. That agreement is a credit default swap. If your buddy doesn't default, you've made a net of $800 and the third person has made $200 for nothing but issuing the promise.


 Let's use the same example with a home. You loan someone $200,000 at 5% interest and take a lien on the house. You, once again, are worried about the debtor making the payments and you really don't want to be in the business of foreclosing on the home and reselling it. You again create a credit default swap with a third person who promises to pay off the mortgage (and get the house) if the debtor defaults and his fee is, say, 1% a year for that guarantee. The guys issuing the credit default swaps are making a fortune so long as everyone keeps paying their mortgage.


Now take the above example and multiply it hundreds of thousands of times with billions of dollars. Here's the really crazy part: It seems like you could also buy a credit default swap even if you had nothing to do with the borrowing or the lending. And credit default swaps weren't limited to mortgages. One of the examples used in This America Life was that one involving GM issuing a $50,000 bond to Person X. If you thought that GM was going under and wouldn't be able to make the bond payment to Person X, you (even though you had nothing to do with GM or the bond or Person X) could buy a credit default swap on that bond. For some fee, a company would promise to pay you $50,000 if GM was unable to meet it's $50,000 obligation to Person X. The greater the risk that GM would go under, the greater the fee. Insane? You bet. And once all the mortgage holders and all the companies couldn't pay back their loans, all the credit default swaps kicked in and the chaos began.


AIG apparently issued a ton of credit default swaps on the bet that they would never have to make them good. Most of the government bailout money has been used by AIG to pay off it's obligations under the credit default swaps. The government feared that if it didn't provide the money, it would have a domino effect (since most of the companies owed money from AIG under the credit default swaps had issued their own credit default swaps.)


And, it's my understanding the credit default swaps were completely unregulated. There was no limit on who could issue them. And there was no requirement that any company disclose how many credit default swaps it held. So when you went to AIG to purchase a credit default swap, you had no idea how many it already held. Caveat: 


The above is probably completely over-simplified and possibly completely inacurate, but it makes sense to me. But I'm open (as always) to listen to those that are smarter than me. Edit: Time magazine reported in its March 30, 2009 issue that AIG is still on the hook for $300 billion in credit default swaps. "Yet the company has a book value of $50 billion." (p. 27)

31 comments:

Anonymous said...

Tell him, Mzchief. You know everything else.

Anonymous said...

well, then you would thnk that the person or company that made the loan that was makeing the money on the monthly pmt and then gets the money from AIG on the defaulted loan after the loan defaulted would have made tons of money. In the free market they would then be able to buy the good assets from AIG when the company went under, and buy the homes from the failing company cheap and sell for a profit in turn making more money. being siad like that the bailout was not needed and prevented other companies from growing producing more jobs and growing the economy. people would be at work and the free market and capitialism would have worked. socialism however always fail;s if that is not true then show one example of it working for a nation.

Anonymous said...

Quit trying to be a Wall Street analyst and bring us your A game. You know, post some booty photos and call it a day.

Anonymous said...

The beauty of capitalism is that it provides the accountability that no one else seems to be able to do especially the government. If you are not successful, you go out of business under capitalism, but not so under Obamaism.

Anonymous said...

I blame the liberal democrats

Anonymous said...

9:56 Simplistic hogwash. Pure Socialism is not employed anywhere. However, Sweden is close as is Canada. These countries enjoy a higher standard of living than the USA. Please also note that countries like Canada have had absolutely no problem with these goofy "capitalist" features like credit-default-swaps. Several other frequently charged "socialist" states like France certainly do have the same financial problems present in the USA. Using the term “socialism” to describe all the world’s problems is passé.

Doug said...

And since the government is there to bail everybody out for irresponsible behavior, we are free to move on to our next irresponsible behavior unscathed from the last.

Anonymous said...

Barry - WOW! Thanks for the Credit Swap post! It is INCREDIBLY important for people to understand CS, because if we don't, we will never get out of this complicated mess.

According to NY Times Finance reporter, Gretchen Morgensen, the money AIG is paying out to their 'partners', is NOT a credit swap settlement (which was my understanding). There has not yet been a widspread default on the underlying debt.
The AIG debt is actually contractual agreement for capital collatoral.

It is extremely complex and confusing. But two big takeaways are:
1. WHY is AIG paying 100% of the contract obligation? US taxpayers have lost an average personal asset value of around 18%. Taxpayers own 80% of AIG. We have negotiating leverage - so WHY don't we demand AIG partners to take a haircut on these contract payouts??

2. Many of AIG CS partners are foreign owned banks (Germany, France, etc). Why are we, the US Taxpayers, bailing THEM out?

3. AIG executive, Liddy, said in yesterday's congressional testimony "the company's exposure to about $1.6 trillion in derivatives." WHAT, WHAT?!!! OMG!

Folks, forget about the executive bonuses.....we are focused on the wrong thing here. There is a much more serious underlying issue we ALL need to understand. This is very serious.

Our news sources are failing to help us understand. Let's demand more.

Two sources of information I recommend is:
1. http://www.nytimes.com/2009/03/15/business/15gret.html

2. Fresh Air interview of Grethen Morgenson: http://www.npr.org/templates/story/story.php?storyId=101936770

Anonymous said...

Your right BG.....boring
Show some more pics of fisher HO

Anonymous said...

10:29 You need to study history a little more. 1) Company cheats and posts huge profits. 2) Executives pay themselves huge salaries and bonuses. 3) Economy shifts and company goes under (or gets bailed out) Executives live high on the hog for the rest of their lives and don't care if the company survives or not. This is the way Republicans have run things forever. Don't blame Obama for the mess made over the last 8 years.

Anonymous said...

I second that 11:37 - Man, it's nice to get some intelligent posts here for a change, instead of people yelling "Socialism" when they obviously don't even understand the concept.

Anonymous said...

Good explanation Barry. Easier to follow than the talking heads on MSNBC or CNN.

My Other Brother Darryl

Anonymous said...

Sounds good to me. What does it take to get you to run more pics of the girl in the pink bikini?

Double Fake Bawney Fwank

Anonymous said...

Three sins that will prove deadly for democracy:

1. IT'S TOO BORING - people become so complacent. If it's not entertaining - they're not listening. (hint - why Obama is going on Jay Leno tonight)

2. IT'S TOO COMPLICATED - thinking about it requires too much effort. Much easier just to say "ah its all socialism" as that relieves them from having to actually think.

3. NO CREDIBLE NEWS ORGANIZATIONS - they don't agree with the facts, and call it biased. Newspapers going out of business. No investigative reporting means no government watchdogs.

Anonymous said...

The two shows from This American Life("Giant Pool of Money" and "Another Frightening Show About the Economy") and the Frontline episode "Inside the Meltdown" should be required viewing. They are fantastic, engaging pieces that do the best job possible in explaining what is happening.

The Credit Default Swap issue is the perfect example of the danger of an extreme free market economy. I don't care what the government does or how big the government is, but what the government should be involved in should be economic oversight. Preserving democracy is more important than preserving capitalism. Let's try to preserve democracy by keeping an eye on the economy, the market, capitalism, etc. After all , these are the things that allow us to live such a privileged life, not the things that make us love life.

PHE said...

Good post, Barry. Your explanation is as clear as I have read. I keep hearing about "This American Life", but haven't checked it out yet.

I keep wondering if the astounding amount of dough we are throwing at this problem isn't only putting off Judgement Day, and maybe actually making it worse when it does come. Are we fixing anything, or just delaying the inevitable? I am nowhere near smart enough to answer that question, but I keep asking it in hopes that someone who is smart enough will answer it for me.

Phillip J Hubbell said...

The only reason socialism works in Canada and Sweden is because it is too cold to go outside and protest what a crappy system it is.

Since there are all these wonderful socialists paradises out there ...we should make a point to get everyone who wants to live that way a ticket.

The United States is a special place...we value freedom above some subjective standard of living. I consider freedom to succeed and get filthy rich as part of my standard of living...how does that compare to Sweden and Canada?

We could have remained part of England and turned into the same panty waist country Canada is...but the people here were of a different breed.

Screw socialism.

Anonymous said...

12:02 & 12:15 - Two more good posts. Are you guys new to this blog? It's a nice change from the redneck BS.

Anonymous said...

well said hubbell.

Anonymous said...

I have been reading this blog for a while, but don't quite understand how the first comment out of the box is against Mzchief, when same had not posted anything.

What's up with that?

Anonymous said...

You may want to read a book called "When Genius Failed." It depicts the rise and fall of Long Term Capital Management. Jon Corzine, Myron Scholes, and Sandy Weill play prominently in the story.

The book is pretty short and has excellent background information on the way Wall Street works, and the basics of CDOs and derivatives, portfolio insurance, and CDS.

I'd check it out if you were interested in reading about how 1 firm, LTCM almost brought down the financial system back in the late 90s.

Of specific importance RE: AIG's bonuses is how LTCM went into a spiral when other Wall Street banks found out the specifics of where LTCM was invested and traded against those investments. Liddy may actually be right that it makes sense to keep those traders who know the "trading book" of AIG from going to rival firms and making the problems worse by further driving down the price of AIGs assets.

Anyway, the book is good.

Anonymous said...

You can guarantee redneck BS on every post Barry makes. You won't see much on this post because it might take some reading and some thinking. Comments usually will consist of the following (paraphrased of course):

1. A comment about Mzchief
2. Our government sucks, and it's the Democrat's fault. Apparently the Republican's poop don't stink.
3. Where da ho's?
4. Move to Canada if you like it so much.
5. Bridgeport is better than Decatur. Apparently it is since no one from Decatur really seems to care about it. Either that or Decatur really doesn't care and it is only a one-sided competition. Bridgeport fighting with itself.
6. "I didn't vote for him"
7. Something racist.
8. "YOU PEOPLE BITCH ABOUT EVERYTHING"

Anonymous said...

I like the way Obama is taking all the blame! That is one way to keep all his buddies from getting in trouble! Very smart.

ALL POLITICIANS ARE CROOKED!
OBAMA IS A POLITICIAN!
THEREFORE, OBAMA IS CROOKED!

ETC. ETC. ETC.

Anonymous said...

I like the way Obammy is taking all the blame, except the part where he inherited this mess, but I don't seeing him returning the money that he got in campaign contributions to the tune of 100 thousand dollars from AIG.

Anonymous said...

AIG gets $165,000,000,000 from the government and you're worrying about a $120,000 contribution to Obama's campaign. Get a relative hold of yourself! (BTW McCain got some $80,000 from AIG).

Anonymous said...

Execs got one tenth of one percent of the bailout in bonuses and your upset?

Anonymous said...

Just so long as the liberal weenies get 4 BILLION dollars for ACORN. That doesn't upset them but a measley 165 millions dollars that they shoved into the stimulus package is now suddenly outrageous and they want it back.

Anonymous said...

I blame Obama

Anonymous said...

I blame the Dems

Anonymous said...

When you guarantee an obligation you incur a contingent liability. You are in effect providing insurance. In this country the government regulates the insurance industry requiring reserves be maintained to prevent such problems. The three companies engaged in guaranteeing each others credit obligations did not call the said guarantees "insurance" therefore there was no requirement for reserves. So, we the taxpayers are bailing out the men/companies that take risks without accountability. Therein lies the problem.

Anonymous said...

Hubbell Bubble Head makes if funny. We can tell he knows Rush is the head of the GOP. And he tells it like he is told to.