Credit default swaps
Financial Weapons of Mass Destruction Why Warren Buffett called Credit Default Swaps financial weapons of mass destruction
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- Let's think a little bit about why credit default swaps are
- famously referred to by Warren Buffet as FInancial Weapons of mass destruction
- At the center of it, and there is not one Credit Default Swap writer
- but I will put one in the middle because each of them are writing many many
- Credit default swaps, AIG is the most famous, but you have some writer here
- they are given some good credit rating.
- May be in the past the credit rating was actually earned in the past by a credit rating agency.
- And then frankly the credit rating agency got a litlte sloppy and really didn't
- wasn't willing to downgrade them given all of them Credit default swaps all of the obligations they are taking on.
- Credit Rating Agencies, as you could tell, I kind of view these guys and these guys as a main culprits
- and may be a little bit of the regulatory agencies saying, Hey look these guys are writing insurance, may be we should actually regulate them.
- But with that said, you have companies over here, I will do the companies in this pink color,
- and they want to borrow money from the other parties.
- Lets say investors, I will do the investors in this orange color, so the investors are lending them money
- The companies gives them interest.
- So investors lending money, giving interest.
- lending money, giving interest, lending money, giving interest.
- And then these investors, and seems pretty reasonable, says hey look, there's this guy over here with a
- double AA rating, the people we're lending to don't have a AA rating.
- This guy has a B, may be this guy has a BB, may be this guy only has a singe A,
- and so he says hey look, I want to be completely safe here so I am gonna pay a little bit of premium
- to AIG, or to the writer, whoever the writer is
- and in exchange I will get insurance. I will get insurance on, on this debt
- I will get insurance
- insurance. And it seems pretty reasonable
- except for the fact that this player right over here
- did not put out any money aside or did not put an appropriate amount of money aside
- to properly account for all of these liabilities, all of these risks that is taking on
- and also all of these risks are correlated.
- You can imagine a situation where the economy goes bad. Now all of a sudden
- this company defaults on its debt and this company defaults on its debt
- In fact when the economy is good is likely that very few of these companies is going to default and when the economy goes bad
- is likely that many of them will default.
- But the real problem is that as soon as these defaults start happening then the credit default swap writer
- is going to have to actually start paying for the defaults.
- They will get the bad debt and in exchange they will make
- the other side of the Credit default swap that the holder of it they will pay to make them hold.
- And so this could take them out of business. And all of a sudden the people are over here
- who are, who thought they had insurance no longer do and they might
- actually say wait I can only hold AA debt and they might actually have to dump this debt on to the market.
- Even worst you have all of the people, all of the people over here
- who didn't lend any money over to any body but they really just wanted to make side bets
- either the side bets might have been pure directional bets
- on the state of the economy saying hey i think a bunch of companies or I think this company in particular
- is going to default on its debt and they too could get credit default swaps really as just side bets.
- So just for may be may be this right here is 1 billion dollars is in debt, may be
- these all of these parties took side bets on this guy
- So even though there is only a billion dollars of debt here, there might be
- four or five or ten billion dollars worth of insurance on that 1 billion dollar bet.
- So if all of a sudden this one company, can't pay it's 1 billion dollars, now AIG is on the line not for 1 billion
- but for 4 or 5 or 6 billion, how ever much it insureded for
- So it allows people to insure for things that they dont have the offsetting liability for.
- And so you can imagine these guys, some of these people if these guy fails will just kind of take a loss
- and that's bad and all of the rest they were expecting that they wouldn't. But some of these players might have had
- offsetting hedges. The only reason that they might have felt comfortable
- taking on some other liabilities is they said look If the economy goes really bad I have, I have this insurance over here
- and they did that transaction with another third party.
- Now all of a sudden if the economy goes bad and these guys said,
- Hey look I am in a lot of trouble good thing I have this Credit default swap but then it
- turns out that they don't because the counterparty here fails, the credit default swap writer and now all of sudden this guys becomes insolvent
- but this guy was dependent on this guy paying and he thought
- he was good because he was even looked into his books and thought that this guy had offsetting hedges
- and now this guy might fail and so you can have this entire cascade through the entire financial system.
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