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.

But those guys are paying a dangerous game. They are basically being insurers. Let's simplify it and call all of them Mr. X.

Here's the crazy part: You, dear reader, if you were a Wall Street hedge fund, could go to Mr. X, the guy who has already proven to be a gambler by offering  the credit default swap on the house, and ask him if he would do the same for you. It's like a Sport Book in Vegas. Yep, you pay Mr. X 1% of the amount of the loan (a loan that you had nothing to do with) and he promises to pay you $200,000 if the debtor defaults. You are simply gambling that the debtor on the home won't pay. The guy issuing the credit default swap takes that bet for 1%. I can't stress this enough: You had nothing to do with the loan. You're just a guy on the street betting on whether someone will payoff a debt.

Now take the above example and multiply it hundreds of thousands of times with billions of dollars by the likes of Bear, Stearns and Lehman Brothers -- Both of whom assumed the role of Mr. X

And when millions of Americans couldn't pay their mortgages because mortgages were being handed out like candy (not because they were forced to but because they wanted to since the mortgage could be immediately sold up the chain), all hell broke loose. And that took America to the brink of collapse.

AIG apparently issued a ton of credit default swaps on the bet that they would never have to make them good. They were Mr. X. Most of the government bailout money has been used by AIG to pay off its 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 inaccurate, but it makes sense to me. But I'm open (as always) to listen to those who 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)