Credit Default Swaps? Does anyone understand them??

[kentuck]

Supposedly, these "derivatives" are at risk to the tune of somewhere between $55-$65 trillion dollars? Are you ready to bail them out also? $55 TRILLION DOLLARS !!!!!!!

I suppose it would be something like, "I will agree to buy that security from you only if you will guarantee its value if it goes under?"

Then you agree to sell it for the funds that you need for whatever reason and you promise to guarantee the security if were to default?

Then, when the it goes under, both parties in the agreement are left holding the bag?

<a snip from www.investopedia.com >

Credit Default Swap - (CDS)

What does it Mean? A swap designed to transfer the credit exposure of fixed income products between parties.
Investopedia Says... The buyer of a credit swap receives credit protection, whereas the seller of the swap guarantees the credit worthiness of the product. By doing this, the risk of default is transferred from the holder of the fixed income security to the seller of the swap.

For example, the buyer of a credit swap will be entitled to the par value of the bond by the seller of the swap, should the bond default in its coupon payments.

[willing dwarf]

1. Paul Krugman has a prettty clear explanation on his blog

Along with slides from an economic conference at Princeton that explores the crisis.

Here's a link: http://krugman.blogs.nytimes.com/2008/09/26/crisis-at-princeton/

[rzemanfl]

2. I have no idea of the bona fides of this source:

http://www.opednews.com/articles/1/CREDIT-DEFAULT-SWAPS--THE-by-Chuck-Simpson-080924-49.html

[FarCenter]

3. You can buy a credit default swap even if you don't own the security

Party B can buy a contract from party A that says that party A will pay the principle and/or interest of a bond issued by Party C, even if Party B doesn't own such a bond.

Although it has an economic function when Party B owns such a bond, the contract described above is basically Parties A and B placing a bet about Party C's creditworthiness.

It is unregulated.

Lots of it is done off-shore, among the off-shore subs of various financial institutions, including the unregulated hedge funds. For eaxample, some hedgie at his keyboard in Newport Beach can buy and sell CDS in London through a hedge fund he has incorporated there.

[JuniorPlankton]

4. Think insurance

I am one of them people who work with CDS (Credit Default Swap) on a daily basis.
The simplest way to imagine them is insurance. You want to be insured against IBM defaulting you pay a certain premium to the seller of protection. The banks make markets in this stuff, they try NOT to have any net positions. If they sell insurance on IBM, they try to buy insurance from somebody else at a better price.

It gets a lot complicated when you add leverage, correlation trading and delta hedging, but insurance is the simplest way to think about this.

[FreakinDJ]

12. Question is "What if they didn't have the CDS"

Would they be "Less Likely to foreclose and short sale the property? and more open to "Write-downs"

Seems to me the CDSs make it more advantageous for banks to force short sales on holdings such as homes further aggrivating the depressed housing market

[kentuck]

13. But if it is Bear Stearns instead of IBM...

You are shit out of luck.

[ancient_nomad]

5. Here's an excellent, long article in OpEdNews....

on Credit Default Swaps. Someone here posted it a couple days ago and I saved it. I wish I could find the original thread for you. This is the best explanation I've read.
Link: http://tinyurl.com/3tsnd9

Here is another post I happened to save. It is also good.
Link: http://tinyurl.com/4w5cxk

The OpEd News one is Looong!

Hope this helps you out!

[gopbuster]

6. Easy answer:

Say you invest in Wachovia. You buy a 10 mil dollar bond (the co uses this money to play with)

This bond pays you 4.75% fixed rate interest

If you wanted to buy insurance on this bond to protect you if the company fails, as of July it would have cost you $375,000 per year to buy this insurance. The insurance is a called a credit default swap instrument. The cost of these fluctuate depending on the strengths and weaknesses of the company concern which makes them tradable for profit.

Wachovia credit default swaps widen 75 basis points
http://in.reuters.com/article/governmentFilingsNews/idINN1527086920080715

Wachovia Credit-Default Swaps Soar to Record After WaMu Failure
http://www.bloomberg.com/apps/news?pid=20601103&sid=aT2iUMMKCC8E&refer=us

[coalition_unwilling]

7. I feel as if I have a pretty good generalist's understanding, altho

not enough understanding to buy or sell one. (My thanks to HamdenRice for his Herculean efforts to educate this board.)

What questions do you have?

[kentuck]

8. And here is a history that will help in understanding...

www.globalresearch.ca

The Wall Street Ponzi Scheme

The Ponzi scheme that has gone bad is not just another misguided investment strategy. It is at the very heart of the banking business, the thing that has propped it up over the course of three centuries. A Ponzi scheme is a form of pyramid scheme in which new investors must continually be sucked in at the bottom to support the investors at the top. In this case, new borrowers must continually be sucked in to support the creditors at the top. The Wall Street Ponzi scheme is built on “fractional reserve” lending, which allows banks to create “credit” (or “debt”) with accounting entries. Banks are now allowed to lend from 10 to 30 times their “reserves,” essentially counterfeiting the money they lend. Over 97 percent of the U.S. money supply (M3) has been created by banks in this way.2 The problem is that banks create only the principal and not the interest necessary to pay back their loans, so new borrowers must continually be found to take out new loans just to create enough “money” (or “credit”) to service the old loans composing the money supply. The scramble to find new debtors has now gone on for over 300 years - ever since the founding of the Bank of England in 1694 - until the whole world has become mired in debt to the bankers' private money monopoly. The Ponzi scheme has finally reached its mathematical limits: we are “all borrowed up.”

When the banks ran out of creditworthy borrowers, they had to turn to uncreditworthy “subprime” borrowers; and to avoid losses from default, they moved these risky mortgages off their books by bundling them into “securities” and selling them to investors. To induce investors to buy, these securities were then “insured” with credit default swaps. But the housing bubble itself was another Ponzi scheme, and eventually there were no more borrowers to be sucked in at the bottom who could afford the ever-inflating home prices. When the subprime borrowers quit paying, the investors quit buying mortgage-backed securities. The banks were then left holding their own suspect paper; and without triple-A ratings, there is little chance that buyers for this “junk” will be found. The crisis is not, however, in the economy itself, which is fundamentally sound - or would be with a proper credit system to oil the wheels of production. The crisis is in the banking system, which can no longer cover up the shell game it has played for three centuries with other people's money.

....more

[Laelth]

9. 55 Trillion?

That's not possible, is it?

:shrug:

-Laelth

[kentuck]

10. That's the conservative estimate....

It is reported that the entire "derivative trades" scheme is like $681 trillion. $681 Trillion dollars!!

[lonestarnot]

15. Holy crap we're done!

From the descriptions here, all currency will be done away with and all nations will have one. There is no fixing this.

[Laelth]

16. I still don't see how that's possible.

Not to be rude, but I need some evidence before I will believe that number.

:shrug:

-Laelth

[pnwmom]

11. Bottom line, we were letting financial institutions gamble

with their clients' deposits. In trading credit swaps, they were betting on the chance that the value of various assets (for example, mortgages) would go up or down. It started out as a kind of insurance against loss, but then they deregulated and let anyone make these bets (even if they didn't own the underlying property).

[Irish Girl]

14. credit default swaps ..

All derivatives are gambling and Wall Street has been acting like a god damn Casino with our money. Derivatives are essentially bets on interest rates, foreign currencies, stocks or specific events like the bankruptcy of a particular company. The interest rate-related bets are by far the biggest. But the bets on bankruptcies — called credit default swaps — are the fastest growing and the most volatile. These derivatives were originally designed to help hedge investments reduce risk — like insurance policies. But in practice, they've been increasingly used to leverage investments, increasing the risks of participants.

The tangled web of bets and debts linking each of these giant players to the other is so complex and so difficult to unravel, it may be impossible for the Fed to protect the financial system from paralysis if just one major player defaults.

To understand why, put yourself in the shoes of a senior derivatives trader at a big firm like Morgan Stanley (which has $7.1 trillion in derivatives on its books and only about $10 billion in capital).

Let's say you're personally responsible for $500 billion in derivatives contracts with Bank A, essentially betting that interest rates will decline.

By itself, that would be a huge risk. But you're not worried because you have a similar bet with Bank B that interest rates will go up.

It's like playing roulette, betting on both black and red at the same time. One bet cancels the other, and you figure you can't lose.

Here's what happens next ...

* Interest rates go up, reflecting a 2% decline in bond prices.


* You lose your bet with Bank A.


* But, simultaneously, you win your bet with Bank B.


* So, in normal circumstances, you'd just take the winnings from one to pay off the losses with the other — a non-event.

But here's where the whole scheme blows up and the drama begins: Bank B suffers large mortgage-related losses. It runs out of capital. It can't raise additional capital from investors. So it can't pay off its bet. Suddenly and unexpectedly ...

You're on the hook for your losing bet.
But you can't collect on your winning bet.

You grab a calculator to estimate the damage. But you don't need one — 2% of $500 billion is $10 billion. Simple.

Bottom line: In what appeared to be an everyday, supposedly "normal" set of transactions ... in a market that has moved by a meager 2% ... you've just suffered a loss of ten billion dollars, wiping out all of your firm's capital.

Now, you can't pay off your bet with Bank A — or any other losing bet, for that matter.

Bank A, thrown into a similar predicament, defaults on its bets with Bank C, which, in turn, defaults on bets with Bank D. Bank D has bets with you as well ... it defaults on every single one ... and it throws your firm even deeper into the hole.

So now do you understand why bookies belong to the Mafia and why gamblers who welsh on their debts wind up at the bottom of the East River? It's because defaulting gamblers are a grave threat to the entire system.

http://www.howestreet.com/articles/index.php?article_id=7457">The Ultimate Wall Street Nightmare