Credit default swaps
Credit Default Swaps 2 Systemic risks of credit default swaps. Financial weapons of mass destruction.
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- So let's see if we can get a big picture of everything
- that's happening in this credit default swap market.
- I'll speak in generalities.
- Let's say we have Corporation A, Corporation
- B, Corporation C.
- And let's say we have a bunch of people who write the credit
- default swaps, and I'll call them insurers.
- Because that's essentially what a credit default swap is,
- it's insurance on debt.
- If someone doesn't pay the debt, then the insurance
- company will pay it for you.
- In exchange, you're essentially giving some of the
- interest on the debt.
- So let's say we have Insurer 1, let's say we
- have Insurer 2.
- And some of these were insurance companies, some of
- these were banks.
- Some of these may have even been hedge funds.
- So these are the people who write the credit default
- swaps, and then there are the people who would actually buy
- the credit default swaps.
- In the previous example, I had Pension Fund 1, that was my
- pension fund.
- Then you could have another pension fund, Pension Fund 2.
- Let's re-draw some of the connections between the
- organizations.
- Let's say Pension Fund 1 were to lend $1 billion to A.
- A will pay Pension Fund 1 10%.
- But Pension Fund 1 wants to make sure that they'll
- definitely get the money, because they can't lend money
- to people with anything less than stellar credit ratings.
- So they get some insurance from Insurer 1.
- So what they do is out of this 10%, they pay them some of the
- basis points.
- So let's say they pay them 100 basis points.
- And in exchange, they get-- I'll call it Insurance On A.
- This is this new notation that I'm creating.
- They get Insurance On A.
- Fair enough.
- And the reason why this I1, this first insurer was able to
- do that is because Moody's has given them a
- very high credit rating.
- And so when they insure something, you're essentially
- the total package, right?
- The loan to this guy, plus the insurance, kind of is like
- you're lending the money to this guy, but you're just
- getting more insurance-- I mean you're getting more
- interest, right?
- So this bond becomes a Double A bond.
- Because the odds that you are not going to get your money
- are not the odds that this guy defaults, but it's now the
- odds that this guy defaults.
- And Moody's or Standard & Poor's have already said.
- Hey, these guys are good for their money, they're Double A
- or whatever.
- So now your risk is really a Double A risk and not a Double
- B risk, or whatever.
- But anyway, this happens.
- This is Corporation B, and maybe Pension Fund 2 wants to
- lend to Corporation B.
- Maybe they lend them $2 billion.
- They get, I don't know, they get 12%, maybe Corporation B
- is a little bit more dangerous.
- But once again, they go to this first insurer.
- And maybe they get some of it-- well let's just say they
- get Insurance On B.
- And B is a little bit riskier, so they have to
- pay 200 basis points.
- 200 basis points goes from Pension Fund 2 to B.
- Now this, already, this is a little bit dangerous, right?
- Because you can think about what's happening.
- One, as long as this insurer does not get a downgrade from
- their credit ratings from S&P or Moody's or whoever, they
- can just keep it issuing this insurance.
- There's no limit for how much insurance they can issue.
- There's no law that says, you know what, if you insure a
- billion dollars of debt, you have to put a
- billion dollars aside.
- So that if that debt defaults, you definitely have that
- billion dollars there.
- Or if you insure 2 billion here, you don't have to put
- that 2 billion aside.
- What you have is a bunch of people who statistically say,
- oh, you know, what's the probability that all of this
- debt defaults?
- So I just have to keep enough capital so that
- probabilistically, whatever debt defaults, I can pay it.
- But you don't keep enough capital to pay all of the
- defaulting debt.
- So you already see an interesting risk forming.
- What if all of these corporations, for whatever
- reason, do start defaulting simultaneously?
- Then all of a sudden this insurance company has to pay
- more out in insurance then it might even have. So you have
- to wonder whether it even deserves this Double A rating,
- because it actually is taking on a lot of risk.
- But in the short term, while these companies are-- everyone
- is doing well and the economy's doing well, it's a
- great business for these guys.
- These guys are just collecting premiums essentially on the
- insurance, without having to pay out anything.
- Now let's add another twist on it.
- These pension funds, P1 and P2, it was reasonable for them
- to get insurance, because they were giving out these loans
- and then they got the insurance.
- So they were essentially hedging the default risk by
- buying these credit default swaps, which was essentially
- just an insurance policy from this Insurer 1.
- But you can have another party.
- This is no less legitimate, really.
- But you could call them-- I don't know-- let's call it
- Hedge Fund 1.
- And they've done a lot of work, and frankly, they often
- are much more sophisticated than the pension fund-- in
- fact, they almost always are.
- And they say, you know what?
- Company B looks really, really, really, really shady.
- I think 200 basis points for the chance that Company B
- defaults is frankly cheap.
- Because I think there's a huge probability
- that Company B defaults.
- So what I'm going to do, I'm not going to lend Company B
- money, because if anything, I think that they're maybe about
- to go out of business.
- But what I can do is I can buy a credit default swap on
- Company B's debt.
- Which is, essentially, I'm getting insurance that they
- fail without actually lending the money.
- So let's say I do that from Insurer 2.
- So I can go and I'll pay Insurer 2 200 basis points a
- year, or 2% on the notional value of the
- insurance I'm getting.
- So let's say it's 200 basis points, and let's say that's
- Insurance On-- I'm making a big bet-- so they're going to
- give me Insurance On B for-- I don't know-- $10 billion.
- And something interesting is going on here already.
- B might not have even borrowed $10 billion, right?
- So all of a sudden you have this hedge fund that is
- getting insurance on more debt than B has even
- borrowed money on, right?
- And it's essentially, you just kind of have this side bet
- between these two parties.
- This party says, you know what?
- I think it's a good deal.
- I get 200 basis points on the 10 billion every year, as long
- as B doesn't default.
- And this guy says, I think B's going to default.
- So I think that's a good deal on that insurance.
- And just so you understand the math, so the notional value is
- $10 billion.
- So what's 2% of 10 billion?
- 2% on a billion is 20 million, so it's $200 million.
- 200 if I did my math correct.
- So they'll pay $200 million a year to this insurer.
- So the 200 basis points on 10 billion is
- equal to 200 million.
- These numbers maybe are a little bit on the big side,
- but who knows?
- Actually, this could be a huge hedge fund.
- This could be a $10 billion hedge fund.
- Or even worse, maybe it's a billion dollar hedge fund, or
- maybe it's a $20 million hedge fund, but they've taken a $180
- million loan to essentially buy this insurance because
- they think that B's collapse is imminent.
- So they're willing to take that bet right now.
- You know, it might be a good bet.
- If B collapses tomorrow, what's going to happen?
- They only dished out maybe 200 million for maybe that first
- year, although you normally pay it on a quarterly basis.
- So they'll pay 50 million every three months.
- Let's say they pay the first payment, 50 million, right?
- And then over the next three months, B just goes bankrupt
- and people realize that debt was worth nothing.
- Then these guys get $10 billion.
- Right?
- But something else is interesting here.
- They probably did insurance to a lot of other people too,
- maybe on B's debt.
- Right?
- Or maybe they also insured A's debt.
- So maybe they gave some insurance on
- A's debt, as well.
- So what happens?
- Let's say B all of a sudden defaults.
- So a couple of things happen.
- I1 is going to owe P2 $2 billion, right?
- I2, the second insurer, is going to owe this hedge fund
- $10 billion.
- Now let's just assume I2's good for the money.
- They have $10 billion they pay to this hedge fund.
- This hedge fund is great, they get great bonuses for the year
- and they go buy yachts, et cetera.
- But this insurer right here, they pay the money they were
- good for but something interesting might happen.
- All of a sudden Moody's finally wakes up, these
- ratings agencies, and says, oh, my God.
- Well, there's a couple of things that might make them
- say, oh, my God.
- First of all, they might say, oh, look.
- You have to pay out $10 billion.
- And I doubt that was the only person you have to pay, maybe
- they have to pay out a lot of money.
- Now I2, Insurance Company 2, you are undercapitalized.
- I am now going to downgrade your rating.
- So, you were Double A, but since you had to give out all
- of this capital, Moody's is now going to downgrade you to,
- I don't know, B+.
- I'm just making these ratings up.
- But that's the sound of how these ratings happen, right.
- A is better, B is worse.
- The more A's you have, the better it is.
- But all of a sudden, when this guy is B+, and this guy
- insured, let's say, some other corporation's debt for this
- pension fund, now all of a sudden this insurance that
- this pension fund had is no longer Double A Insurance.
- It's now B+ Insurance, and maybe this pension fund, by
- its charter, can't hold something that
- has a B+ credit rating.
- So they're going to have to unwind the transaction, or
- maybe they'll have to unload the debt that was insured.
- So one, just by Company B defaulting, maybe this guy was
- holding some of Company A's debt, and it was insured by
- Insurance Company 1.
- Now they're going to have to unload that debt.
- So just one default creates this chain reaction, right?
- This one default happens, this guy has to pay this guy money,
- then this guy gets undercapitalized since they
- have to pay out money.
- Then Moody's says, oh, my God, you're undercapitalized.
- We're going to reduce your ratings.
- Maybe this guy was insuring some of A's debt, but now
- since he was insuring some of A's debt, all of a sudden that
- insurance is worth less because it has a lower rating.
- And now A's debt, less people want to hold it, because there
- are less people to insure it.
- I know that's very confusing, but this is really the point
- that Warren Buffett was saying when he said that the credit
- defaults swap market, or in general, the derivative
- market, are financial weapons of mass destruction.
- Because you have so many people who didn't have to set
- aside a capital, right?
- This guy could insure $10 billion worth of debt without
- having to set aside $10 billion.
- And you have so many people making all of these side bets,
- but they're all making two core assumptions.
- One, that these rating agencies's ratings are valid.
- And two, that the other person is good for the money.
- But if all of a sudden you have one failure someplace in
- the system, you could have this cascade where one,
- there's just a lot of downgrades.
- And then a lot of the people end up not being
- good for the money.
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