TJP

Credit Default Swaps

By Byron A. Ellis-November 01, 2008

A credit default swap (CDS) is, basically, an unregulated financial insurance whereby the buyer makes periodic payments to the seller in exchange for the right to a payoff if there is a default or credit event in respect of a third party or reference entity. Its original purpose was to transfer credit exposure from holders of a fixed income security to the financial firm that sold the CDS. However, over time it morphed into a betting game.

Thus, instead of insuring the owner’s security from default risk, banks and hedge funds allowed individuals without securities to buy insurance against securities that they did not own.

The process is akin to owning a home and insuring it with the ABC insurance company against unforeseen adverse events. And, the ABC insurance company to increase its profits allows others to buy insurance against your home without owning it.

Say, an investor bought a bond for a billion dollars and pays 2 percent per year for insurance to a hedge fund. The hedge fund makes a cool $20 million per year. But, in order to boots revenues, it sells additional insurance against the investor’s bond, say to another 20 individuals; now, its yearly revenue increased from betting on that single bond to $420 million.

However, if the seller of the bond defaults, the hedge fund has to pay out $21 billion dollars; so, the hedge fund hedges the bets by purchasing insurance for an equal amount owed money, $21 billion.

Ultimately someone is liable for the $21 billion dollars. Yet, the scope of the liability is not known. Therefore, any financial institution could be liable for billions of dollars in CDS. And, it is this uncertainty that creates the credit crunch.

The Depository Trust Trading Corp., (DTTC) has registered more than $47 trillion of CDS; roughly twice the size of the U.S. stock market and far in excess of the $7 trillion mortgage market. Some analysts believe that the bankruptcy of Lehman Brothers was tied to about $400 million in CDS.

A board of members controls the DTTC, which includes JPMorgan Chase & Co., Goldman Sachs Group Inc. and other dealers that created and controlled trading in the credit-default swap market.

Thus, for former members of the Goldman Sachs Group to have advocated for a taxpayers’ money to bailout and to be in charge of managing the distribution of bailout funds to financial institutions is a travesty and a great conflict of interest.

Furthermore, it is callous to deflect blame for the economic crisis on the sub prime mortgages; such deflection was a deliberate red herring.

The sub prime market is no more than 14 percent of the mortgage market. Thus, it is clear that the credit crisis is not a sub prime problem. Rather, it is a problem created by banks and brokerage firms and it is not related to the so-called “easy credit.”

For the new administration to establish credibility, it must immediately disassociate itself from the conflict of interest associated with the former Goldman Sachs personnel.

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