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## Finance and capital markets

### Course: Finance and capital markets>Unit 10

Lesson 3: Credit crisis

# Credit default swaps 2

Systemic risks of credit default swaps. Financial weapons of mass destruction. Created by Sal Khan.

## Want to join the conversation?

• : I dont understand how can the Hedge Fund H1 get the Insurance without having to actually lend the money to B company?
• @Nivedan

B has nothing to do with this setup, except being the company that is being bet on. It's like asking what does that horse have to do with people betting it will win the race. People betting on it winning or losing are not giving any money directly to the jockey or the horse owner, their contracts state how much they will get if they win or not, that's it. You can bet 1 billion \$ that the horse will win if you want (assuming you find someone to take the bet), but that won't give the jockey 1 billion \$, or even a fraction of it.

If you want to push the comparison further, imagine this : every month, there is a race, which ironically (from H1's point of view) B loses if it stays solvent, or 'wins' if it defaults. H1 is placing a bet, with I2, that B is going to 'win', i.e. default. So, I2 accepts to place this bet at 1 : 50, i.e. you give me 1\$ to place the bet, if B 'wins' I give you 50\$ (or in this case, \$200M vs \$10B). So each month that B loses, I2 is collecting his 1\$ from H1 and being happy. Then one day, B actually wins, and I2 has to give 50\$ to H1. And, well, there won't be other races for B after that.

If B loses 50 times before winning, I2 is doing a good deal. But if B wins after a month... not so much.Now imagine that I2 actually accepted a lot of these bets, maybe from H1, H2, H3, etc. on this monthly race and some other monthly races. But it never had the money to pay them back in the first place, it just assumed basically that the horses would always lose (although honestly it's more a case of I2's executives making a LOT of money as profits and bonuses as long as horses lose, and they assume they will likely just be out or find another job if these horses actually start win, leaving with a lot of money because their personal accumulated wealth is not on the line here), or that it will manage to get enough monthly money overall to make up for when it has to pay, or use previously owned assets. But they leveraged WAY too much and couldn't handle the payments in many cases.

This is PURE gambling, there is nothing else. Don't look for anything more complicated than that. The only difference is that it is not regulated as such. It's all rather confusing verbiage by financial companies to not say directly that the Credit Default Swap market turned into one big casino. But when the casino can't pay its losses, they use taxpayer's money for it, because "this casino is too big to fail and it would hurt the economy too much to let it go under".
• Even if all of the risk could be conservatively and wisely quantified and managed and therefore did not create the vulnerability that it did create, how is this sort of financial activity (ie betting) in any way helpful to the real wealth producing (what is left of it) part of the economy?
• Honestly, I do not see anything helpful at all in the fact that you can take CDS against a company you did not invest in either. It is a total distortion of the point of finance, it does not create wealth in any way at all (and it actually contributed to destroy it, as Sal shows...)

@ jason.smith
I think it's important to keep a distinction however between taking insurance on an asset you own, which did help A in this example get funding despite being risky, and betting on something that you do not own. H1 here does not give ANY money to B. Neither does I2. It's just a bet between them on if B will default or not. And it's very easy to imagine situations here where H1 would WANT B to default, it's much more lucrative for them, and if they could influence this they would likely happily do so. H1 and I2 here are doing absolutely nothing good for the economy, they're both just trying to make cash for themselves without producing anything concrete. No wealth is being produced out of it, and even worse, I2 could have to pay more money than it actually owns, which would force it to take away investments it might have in real wealth-producing enterprises to pay that debt to H1. And H1 will take this big profit and pay huge bonuses to its executives. It is not helping the economy. At all.
• How is it possible for the Hedge Fund to take out insurance worth \$10B on B's debt if B's debt is only \$2B in the first place!?
• CDS has nothing to do with B's debt. This whole crazy market probably started the way Sal started video 1 - a pension fund needed to lend the money to make an income and needed it insured.

Now it got completely out of hand and corporations are simply just betting that other companies are going to fail.

For example: Imagine if I went over to you and said: "Hey I think Google is going to go bankrupt." You say: "Are you out of your mind?"

So we bet for a 10 year period. I pay you \$1,000,000 a year. If Google defaults within the 10 years you have to pay me \$50,000,000!

You think: "Hey this is never going to happen. Easy \$1M a year for me!"

But what if it does...
• In having mentioned all the credit default swaps as insurance policies, etc., why haven't you mentioned that the ultimate insurer which helped to begin the whole upside down market incentives began when the Federal Government fully insured (or backed) the vast majority of the real estate loans, even as they were made only to be packaged and sold? If anything is a little shady surely that is?
• The federal government was not fully insuring the vast majority of real estate loans until after they took Fannie and Freddie into conservatorship in 2008.
• Is it possible that a an issurance company can be insured but another?
• Yes, this is called reinsurance, and it is common.
• Probably a silly legal question here: Why is Hedge Fund #1's Credit Default Swap not considered to be gambling? (and thus either regulated by Gaming Control Boards or illegal in most states)
• Hmmm... I got the comparison but isn't is really silly to call it an "insurance" when H1 does not have an inch of relation to Corp B (the company they are betting would default)? Or is it really even "real insurance"? How is "insurance" even defined here? How were these allowed as such? Or am I missing some hidden implications/connections between Corp B and Hedge Fund1? Because this to me simply is just gambling.
• So would it be legal for I2 to loan money to B in order to keep them from going under? After all, a billion dollar loan (or even a GIFT!) might save company B from going under, and therefore, stop I2 from being on the hook for 10 billion.
• What are some examples of companies that offer insurance for Credit Default Swap ?
• Credit default swaps are usually issued by banks and insurance companies. For a small fee a CDS will provide protection against the default of a given bond. You can buy CDS for any bonds that have been issued to the public.
• How is it legal for "Hedge Fund 1" to do this? They're not loaning money to "Company B" so there is nothing to insure. They seemingly have no insurable interest in "Company B's" debt.