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Current time:0:00Total duration:12:04

Video transcript

so let's see if we can get a big picture of everything that's happening in this credit default swap market so I'll speak in generalities so let's say we have corporation a corporation a corporation B corporation C and let's say we have I don't 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 and in exchange you're essentially giving some of the interest on the debt so let's say we have insurer one insurer one let's say we have insurer two 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 swap so in that in the previous example I had pension fund one that was my pension fund and then you could have another pension fund pension fund - and let's just see let's redraw some of the the connections between the organizations so maybe I let's say pension fund one were to lend 1 billion dollars to a a will pay pension fund one and no 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 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 that's and the reason why this this I won this in 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 it's 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 you're getting more interest right so this bond becomes a double a bond because it's the the odds that you are not going to get your money are not the odds that this guy default but it's now the odds that this guy default and Moody's or the standard of support and poor's have already said that hey you know these guys are good for the 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 you know this is corporation be and maybe pension fund to wants to lend the corporation B I know maybe it's maybe they lend them two billion dollars and they get they get I don't know they get twelve percent maybe corporation B is a little bit more dangerous but once again they go to this first insurer and I don't know maybe they get some of it they get oh 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 to 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 the 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 actually you have that billion you definitely have that billion dollars there or if you if you insure two 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 and you know 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 interest risk forming what if all of all of these corporations for whatever reason do start defaulting simultaneously then all of a sudden this insurance company has to pay more out insurance than it might even have and 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 you know 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 you know these pension funds p1 and p2 it was reasonable for them to get insurance because you know they were giving out these loans and then they got the insurance so they were essentially hedging the default risk right by buying these credit default swaps which was essentially just an insurance policy from each of from this insurer one but you could have another party and you know this this is no less legitimate really but you could call them Anna let's call it hedge fund one hedge fund one and they've done a lot of work and frankly they often are much more sophisticated than the pension funds 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 default is frankly cheap because I think there's a huge probability that Company B default so what I'm going to do I'm not going to lend Company B money because I'm anything I think that there may be about to go out of business but what I can do is I can buy a credit default swap on companies B 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 to so I can go and I'll pay insurer to 200 basis points a year or 2 percent on however on the the notional value of the insurance on getting so let's say it's 200 basis points and let's say that's insurance on you know I'm making a big bet so they're going to give me insurance insurance on B for I don't know 10 billion dollars and something interesting is going on here already B might not have even borrowed ten billion dollars 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 that's 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 ten billion every year as long as B doesn't default and this guy says I think B is 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 ten billion dollars so what's two percent of ten billion so you see two percent two percent on a billion is twenty million so it's two hundred million dollars right two hundred B if I did my math correct so they'll pay two hundred million dollars a year to this insurer so the two hundred basis points on ten billion is equal to two hundred million these numbers maybe are a little bit on the big side but you know who knows actually some hedge funds this could be a huge hedge fund this could be you know a ten billion dollar hedge fund or even worse they might have maybe it's a billion-dollar hedge fund but they've taken or maybe it's just maybe it's a twenty million dollar hedge fund but they've taken a 180 million dollar loan to essentially you know they to 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 right 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 you know that debt was worth nothing then these guys get ten billion dollars right but something else is interesting here I - they probably did insurance - a lot of other people - maybe on B's debt right or maybe they also insured maybe they also insured A's debt so maybe they gave some insurance on A's debt as well right so what happens let's say B all of a sudden be all of a sudden defaults right so a couple of things happen I one is going to op2 let's see I don't know how much they two billion dollars right I to the second insurer is going to owe this hedge fund ten billion dollars now let's just assume just I too is good for the money they have ten billion dollars they pay to this hedge fund this hedge funds great they get you know great bonuses for the year and they go buy yachts etc but this insurer right here they paid the money they were good for it 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 things that might make them say oh my god first of all they might say oh look you had to pay out ten billion dollars and I doubt that that was the only person you have to pay maybe they've to pay out a lot of money now I to insurance company to 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 that's the sound of how these ratings happen right a is better be is worse the mores you have the better it is but all of a sudden when you when this guy is b-plus that and this guy insured let's say some some other corporations debt for this pension fund now all of a sudden this insurance that this pension fund had is no longer worth is no longer double-a insurance it's now B plus insurance and maybe this pension fund by its charter can't hold something that has a B plus credit rating so they're going to have to unwind the transaction or maybe they'll have to unload the debt that was insured right so one just buy Company B defaulting maybe this guy was holding some of companies A's dead and it was insured by insurance company one now they're gonna have to unload that debt so just 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 says oh my god your undercapitalized we're going to reduce your ratings maybe this guy was insurance insurer some of ADEs debt but now since he was insuring some of A's debt all of a sudden that that that insurance is worth less because it has a lower rating and now a is a zet less people will 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 when when he said that the the credit default swap marketer and 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 dollars worth of debt without having to set aside 10 billion dollars 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 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 can 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