Untangling credit default swaps

my name is Patty Hearst I'm a senior editor of marketplace and today I'm going to talk to a little bit about credit default swaps a lot of people have been talking about credit default swaps or CVS recently and talking about them being part of the cause for the whole financial meltdown that we're seeing right now and they aren't a part of the course but they're not the main cause although some people would some people are beginning to point the finger at them the essentially water credit default swap is it's a contract that a bank is saying with another Bank or another financial institution and these contracts have spread all the way throughout the system they count for trillions of dollars of contracts that's right the financial system they've glued all the banks together so when a bank starts to collapse because of its exposure say to and CDOs or bad mortgages or whatever it may be the credit default swaps is begin is because it's glued that Bank to a number of other banks is beginning to drag all the banks down with it it's obviously a very complex but at its heart a credit default swap it's not it's not outcome it's nothing secret essentially what it is it is it's an insurance contract and when you've been reading their papers recently you've probably realized that people are not pulling them credit for swaps anywhere anymore they're calling them insurance so that's just call it insurance rather than using a CVS or credit default swap alright so here we have our insurance and we've got two characters all right we've got Sam who's a banker we've got Jim who is his old frat fraternity brother who works for an insurance company say just for argument's sake AIG now Simon he becomes a banker first thing he does is he goes out and he buys a Ferrari because either bank cares a love fast cars now what he has to do many a safari has to insure it so he kills his old friend friend Jim and he says hey I've got this new Ferrari I need to ensure it can you do me a deal jim says absolutely the usual terms apply you know I will make you whole if this if your Ferrari is isn't in an accident in some way I'll pay you some money a big bag of money and in return you pay me a premium now at the same time Sam did his first deal of the bank and his first deal was he bought five million dollars in General Motors bonds okay so that's what he bought five million dollars that was a little nervous in a General Motors is a good company by the time that he bought it but he's a little nervous and he's got this shiny deal then he wants to ensure that to assert brings up German he says Jim I bought five million dollars in GM bonds can you insure them for me and jim says well how can i do that it's as well it's the same way same with you insured my Ferrari you know if the bonds default when they trade down in the market then you make up the difference so that I'm still worth five million on my deal and in return I'll pay you a premium every month so instead of an insurance company on a car what we've got is an insurance company on five million dollars a General Motors bonds and lasts for five years say I'm five million dollars and that is essentially the credit default swap what's happened it's an insurance contract Sam has swapped the risk now Jim holds the risk and in return Jim is getting a premium say one hundred thousand dollars it's paid every year for five years until the contract expires just like an insurance contract on his Ferrari so that's the basic concept of a credit default swap but there is a slight wrinkle and the wrinkle is but in order to make sure that Jim will actually pay up that money if there is a default on the General Motors bonds he wants Jim to put up some collateral okay so it goes to G and when he says like AIG is a big company you guys have got loads of money so I'm not gonna need too much collateral that's just saying five hundred thousand so there's the collateral that deal now obviously if General Motors bonds go south and Jim has to pay the bag of money to make sound good then he could take that money from the collateral and pay up or define what just goes away whatever at the end of the five years if the contract expires just like an insurance contract if the contract expires and the 500 mil 500 thousands of dollars in collateral goes away Jim takes that bike meanwhile he's had the hundred thousand dollars every year which is keeping him in the deal so and that's the little wrinkle that makes accredit the full swap different to insurance contract with like a regular insurance company but this collateral package is a bit of a problem for AIG and we saw how it was a problem recently because Sam may not be the only person that Jim is doing an insurance deal with on st. generally response or anything else for that matter he may have done a deal with bankers all over the world all over the country forever in each one of these situations he'll offensive so he will have to have surrendered a collateral package of $500,000 now what happens if General Motors starts to look a little risky right now the AG is rated triple-a by Standard & Poor's the standard of course realizes that Jim has all of these other contracts and in each case he's got $500 five hundred thousand dollars in collateral and in each case he's going to be having to pay out money to all of these counterparties in the deal because General Motors is getting a little risky so stubborn report says well maybe the AG's not worth triple-a anymore maybe we're gonna knock them down to wait for example now Sam is a smart guy in his contract he has said if you get downgraded you've got to pay me more collateral because I'm you're more of a risk to me the risk is now not only is there a risk that General Motors is going to default it's also a risk that Jim might not be good for the money so in order to insure against that risk of secondary insurance if you like Sam is asking for multi-level so you'll ask for one point five million dollars in battle it also means that every single one of these other counterparties also wants an extra million dollars in Somali Jim is finding himself being dragged down by all of the demands all these what are called collateral calls and of course then standard of course what is this and thanks for maybe well knock him down even further Duncan look at them to jump range and again the collateral call goes up and that's what happened to AIG was dragged down by all of these collateral calls which nearly put it in the hole now people ask me how does the how do you determine what the bag of money is that these guys are gonna pay across was just the same way that if you're if Sam's Ferrari is damaged in some way the insurance company makes an assessment and pays out what it thinks what it needs to make sounds for honor of the sons Ferrari whole and brand spanking you again in the case of the General Motors bonds the the arbiter is not the kid the insurance company the arbiter is the market is Sam now that General Motors has default it will try and sell those bonds in the market and say for example they trade at I don't know 60 cents on the daughter Jim has agreed to make Sam whole so we didn't make sure that he has five million dollars complete so because of that secondary market trade Jim now knows he is going to have to pay Sam two million dollars and that is the meet that that is the make hole pays to sign in order to keep him complete now the tricky bit about this is that obviously it's an insurance contract and there are many of these shippers surance contracts out there a tricky bit of if it is that companies like AIG have done credit default swap deals with hundreds if not thousands perhaps even millions of other counterparties likewise Sam might have done these other deals as well and not only is Sam or not only as Jim insuring Sam Sam might be insuring other people so Sam doesn't necessarily have to be the present being protected he can also be the person selling the insurance and so what you have is an enormous wave so Sam is insuring other people or being insured by other people and they may in turn be insuring each other and that's where the web comes in so when you look at a company like Lehman Brothers or AIG failing for whatever reason the failure starts to drag down the rest of the system because Lehman Brothers has been tied in through all these contracts with a number of other financial institutions so his little brother starts to Teeter or AIG starts to teacher it can't unravel with these deals and it starts to try other banks down with it and Lehman Brothers even now in this situation where the members have been broken up and sold people are still unsure what happens to those contracts and Lehman Brothers was supposed to pay certain amounts in collateral that was it was an you know it had agreements to pay out and even in events of defaults and people indeed have been betting on Lehman Brothers so what you have is this this web that is that is starting to suck people down but in the end the thing that irritates people more than everything else the credit default swap market is that as you can see there's an insurance contract the credit default swaps are insurance contracts but they're also bets because Sam in this case owns five million dollars of GM bonds it doesn't necessarily have to have any exposure to TM at all he may just decide that he wants to bet that GM is gonna fail and it's quite legal for him to do that unlike if you Red Sox which you know would be illegal but he's quite able to make that bet with Jim Jim's able to take the bet and you can do that with any company that you like and these these default swaps are traded over-the-counter which means that nobody knows how many there are or whose or view what what deals have been done and who's done with whom the nobody's obliged to tell any regulatory agency in any SEC so consequently not only do we have an enormous where there's a binding all these banks together without web is of an unknown quantity nobody knows how big it is and how far it extends or who's involved and we only find out whenever a company begins to collapse and suddenly it finds itself you know a second bank finds itself big dragged along with it and a third and a fourth and so on and on ad infinitum and that's the situation that we find ourselves in today

Channel: Marketplace APM

Views: 65,134

Rating: 4.9247651 out of 5

Keywords: Marketplace, business, money, creditDefaultSwaps., financialCrisis, Borrow, Spend, Cost, Supply, Demand, Big banks, Put up dough, Stake, Trust fund, Exchange, Barter, Vend, Offer, Auction, Traffic, Unload, Deal, Dump, Hustle, Recession, Austerity, Financial crisis, Thrift, Layoff, Field, Trade, Work, Career, Livelihood, Occupation, Vocation, Commerce, Financial affairs, Money, Accounts, Economy, Analysis, News, regulation, Paddy Hirsch, MarketplaceAPM

Id: KhI5qy-L4cc

Length: 10min 47sec (647 seconds)

Published: Mon Nov 03 2008