Credit default swaps

let's say that I'm a pension fund and I have money to lend to other people and I want to lend it to other people because it that way I can get interest on it instead of it just kind of sitting and doing nothing and if I lend it to someone other than the government I'll get better interest so let's say that there's so let me let me draw me I'm the pension fund maybe I'll draw me in magenta so that's me pension fund pension fund pension fund and let's say that there's some corporation I don't know let's say it's GM they make cars I think you've heard of them some corporation GM but let's just call them Corporation a corporation a they need to borrow money maybe to buy a factory or to do something else we're not going to get involved in what they need the money for and I'd like to lend them the money but there is an issue there's an issue here I'm a pension fund I manage I don't know I manage the retirement fund for the teachers of California or for the Auto Workers of Michigan or whatever and part of my Charter says that I can only invest in very very very safe instruments so I'm not allowed to go gamble people's money because this is you know this is people's retirement so I can't do very fancy things with it so I can only invest in things that are rated triple-a or let's say double-a I'm just kind of making this up on the fly so triple-a would be like the highest rated securities right these are things that have a very low chance of default but corporation a is only rated I don't know triple let's say it's rated BB and actually this is a good time to think about well who's doing all of these ratings and you might think oh it surely is a government entity because only the government would be objective enough to give all of these corporations frankly objective ratings but unfortunately it's not they're private entities the private entities that are actually paid to rate things and I think I touched it touched on it in the video on collateralized debt obligations but their incentives are a little bit strange but let's say I have Moody's Moody's is one of the ratings agencies and they rate corporation a as BB so they've said no you know these guys they're pretty good but you know they're not like the US government or something there's a there's a chance that they can go under for whatever reasons or that you know they're they're sensitive to the economy as a whole and I say man you know I would love to lend these guys money I would love to lend these guys the I don't know the billion dollars that they need and these guys are willing to pay me eight percent interest but I can't do it me as a pension fund I cannot lend the money because I'm only allowed to lend money to I don't know single a or above types of bonds or you know I can only buy single a or above type of instruments so what do I do i this guy needs money I have money to give him but he's his he's kind of corporate credit rating that was given by Moody's just isn't high enough for me to lend him the money and this is where credit default swaps come in so in an ideal world I would give corporation a I would give them a billion dollars and then maybe they would annually give me I don't know let me make up a number ten percent ten percent per year and then this might have a term for ten years and after ten years they'll pay me the billion dollars back and then I'll be happy but as I said multiple times I can't do it because they are BB rated and my Charter says I can only invest in a rated bonds so I go to another entity and let's let's call this entity AIG and these entities are essentially insurance companies on debt and I'm calling this one AIG because AIG was actually did do this but it could be anything a lot of banks did this a lot of insurance companies did this there were some companies that just specialized in writing collateralized sorry in writing credit default swaps baby what does AIG do for me well first of all it's important to note that Moody's has given AIG I don't know let's give it a double A rating I don't know what their actual rating was they said you know what they are almost risk-free they're almost like the US government Moody's has looked at their books or supposedly or hopefully has looked at their books and says well you know they're there if you loan them money they're good for it so they have a very very high rating although once again you have to worry about the incentive because who paid Moody's to give them that rating and whenever there's you know you're getting paid to give a rating you have to wonder about what your incentives are in terms of how you rate things but anyway that's that's that's a discussion for another video but what AIG says is you know what pension fund I know you want to lend corporation a money and corporation a wants to borrow money from you but you have this problem because they're double berated so we're going to do is we're going to ensure we're going to ensure this bond we're going to ensure this loan that you're giving to corporate B so what we just want in return for that is an insurance premium we want you to pay us a little bit of this interest every year if you pay us a little bit of this interest every year we will insure this payment so you get 10% a year and I don't know you give us 1% a year so you give us 1% a year so 1% a year 1% a year and this is also 1 percent just in just to learn a little bit of financial jargon this is also you know someone would say 100 basis points a basis points is one one basis point is one hundredth of a percent so one percent is the same thing as 100 basis points 2 percent is the same thing as 200 basis points so you pay me a hundred basis points of the 10 percent per year and in exchange I will give you insurance I'll give you insurance insurance on on A's debt and in fact it might have not even been structured this way it might have been structured so that corporation a right here before even issuing the bonds they include this insurance with the bonds so instead of taking 10 percent instead of giving 10 percent they cut out 1 percent to insure it and then these essentially become triple Double A bonds and why is that well this is their double B but you're being insured by someone is double-a so all of a sudden these bonds because they're being insured by this entity that is double aid which Moody's has you know determined is double-a these bonds are now good enough for my pension fund to hold because I say you know what even if corporation a goes under I have this double a guy insuring it and so I'm fine so this is the equivalent of holding double-a bonds and what's my effective interest rate well I'm getting nine percent per year right I'm getting 10 percent per year from corporation B and then I have to pay 1% to AIG and if corporation B goes under tomorrow AIG is going to give me my billion dollars back and you might say hey Sal this sounds like a like a pretty good situation and and and and this is where it starts to get a little bit shady because AIG they're not just insuring my my debt or my my loan that I gave to corporation a and think about it AIG didn't have to do anything and you didn't have to put up any collateral AIG didn't say didn't say oh you know what out of all of our assets here is here is a billion dollars that we're going to set aside just in case corporation a doesn't pay right you would think that if you wanted to be guaranteed that this money was going to come to you this AIG corporation would have to set aside the money but they didn't have to do that they just had to say hey Moody's has said we're Double A we're good for debt we're good for insurance so you just pay us 1% a year and trust us or trust Moody's that we really are good for the money they never had to set aside the money so you're just kind of going on built on a leap of faith that if and when corporation a defaults AIG is going to be good for the money now this is where it gets interesting let me let me erase Moody's from the screen actually maybe I'll I'll do it I'll go down here AIG didn't just insure my debt let's say that there is Corporation C's debt Corporation C Corporation C let's say that there be I don't know they're all these ratings have different terminologies you'll see their b plus rated right and let's say there's 10 billion dollars of at that they borrow from some other party ten billion and then then return I don't know they give eleven percent and this is I don't know this is pension fund B pension fund B and these this pension fund had the same problem they can only buy a rated or above bonds so AIG also insures their their debt that they gave to corporation C so maybe they'll pay them corporation C is maybe a little bit riskier so out of the eleven percent I have to pay maybe I don't know 150 basis points or one-and-a-half percent that's the same thing as one percent and in exchange they insure insure C's debt now something very interesting can happen here AIG all of a sudden has an excellent business model right because they were able to get this double A rating from Moody's they can just keep insuring other people's debt and they don't have to put any money aside right they don't have to they don't have to set give this their their assets to anyone else and they just get these income streams right from from my pension fund they're getting 1% per year of the billion dollars from this pension fund they're getting one and a half percent one hundred fifty basis points per year and they could do this frankly as much as they want they could do this a thousand times and as long as Moody's doesn't get suspicious as long as Moody's say doesn't start saying hey wait wait wait a second AIG you only have a hundred billion dollars in assets but you have insured a trillion dollars of other people's debt something shady going on I'm going to lower your rating as long as that doesn't happen this AIG corporation can just keep insuring more and more debt and frankly as long as none of that debt goes bad they just get this excellent income stream and their CEO will get excellent bonuses anyway I think you start to see where you're having a single point of failure in a kind of a house of cards and I'll continue that in the next video