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Current time:0:00Total duration:3:20

Video transcript

let's say that I run some type of a pension fund and I have 1 billion dollars that I need to invest someplace and I dig around a little bit and there's this company a over here and it needs to borrow a billion dollars and it's willing it's willing to give 10% interest in exchange for borrowing that billion dollars so if I give these characters over here my billion dollars if I lend it to them if I lend them the billion dollars on an annual basis they are going to give me ten percent interest there's a problem here though the rating date the rating agencies the ones that in theory should be independent they've only given the company a a double B rating and this is a pension fund I have to only invest in the safest of safest of securities I have to invest only in things that are double-a and so here might enter a character like AIG and obviously things have changed since their heyday but AIG based on at least Moody's perspective it has a double-a rating so AIG could say hey look pension fund why don't you lend them the money and what we're going to do is enter into a credit default swap and what that essentially is is a form of insurance of that 10% every year why don't you give us one percent of that and in financial lingo that sometimes referred to as a hundred basis points and in exchange for that in exchange for that hundred basis points a year you can view this as the insurance premium we are going to we are going to insure we are going to ensure that if for whatever reason Company B or sorry Company A defaults on that debt you can give us the debt you can give us you can give us that that debt security and we will just give you back your billion dollars now from the pensions point of view this sounds pretty good they're now getting a net nine percent of interest ten percent minus the one percent and they're essentially getting getting to lend to a BB company but it's in effect like lending to a double-a because as long as AIG is good for the money then the pension the the pension fund is going to get their money back one way or the other now where this gets a little bit shady is AIG right here didn't have to do anything what's what's interesting about credit default swaps credit default swaps sometimes refer to CBS's is that even though they are insurance for all purposes they are insurance they are not regulated like insurance so typically an insurance company when they insure something they have to set aside some money in case that thing actually happens and they have to work out the probabilities and all that the credit default swaps were not regulated in that way so AIG could do this without having to set aside any type of money and they can do this over and over and over and over again kind of snowballing all of their potential liabilities and so you can imagine it's really good money while no one is defaulting but all of a sudden while people when people start defaulting then all of a sudden AIG is going to be in trouble and all the people who thought they had in effect double a debt because AIG was insuring it might not