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Studying for a test? Prepare with these 7 lessons on Options, swaps, futures, MBSs, CDOs, and other derivatives.
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Video transcript
Let's think a little bit about why credit default swaps, or famously referred to by Warren Buffett as financial weapons of mass destruction. At the center of it-- and there's not just one credit default swap writer, but I'll 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're given some good credit rating. Maybe in the past that credit rating was actually earned by a credit rating agency. And then frankly, the credit rating agency got a little sloppy and really wasn't willing to downgrade them given all of the credit default swaps, all of the obligations they are taking on. And as you could tell, I kind of view these guys and these guys as the main culprits, and maybe a little bit of the regulatory agencies saying, hey, look, these guys are writing insurance. Maybe we should actually regulate them. But with that said, you have companies over here. I'll do the companies in this pink color. And they want to borrow money from other parties, let's say, investors. I'll do the investors in this orange color. So the investors are lending them money. The companies give them interest. So investors lending money, giving interest, lending money, giving interest, lending money, giving interest. And then these investors-- it seems pretty reasonable-- say, hey, look, there's a guy over here with a double A rating. The people that we're lending to don't have a double A rating. Maybe this guy has a B, maybe this guy has a double B, maybe this guy only has a single A. And so he says, look, I want to be completely safe here so I'm going to pay a little bit of a premium to AIG or to the writer, whoever the writer is, and in exchange I will get insurance on this debt. 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 the appropriate amount of money aside to properly account for all of these liabilities, all of this risk that its 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's good, it's likely that very few of these companies are going to default and when the economy goes bad, it's likely that many of them will default. But the real problem is is 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'll get the bad debt and in exchange they'll make the other side of the credit default swap, the holder of it, they will pay to make them whole. And so this could take them out of business. And all of a sudden, the people over here who thought that they had insurance no longer do. And they might actually say, wait, I can only hold double A debt and they might actually have to dump this debt on to the market. Even worse, you have all of the people over here who didn't lend any money to anybody, 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 maybe this right here is $1 billion in debt, maybe all of these parties took side bets on this guy. So even though there's only $1 billion of debt here, there might be $4 or $5 or $10 billion worth of insurance on that $1 billion bet. So if all of a sudden this one company can't pay its $1 billion, now AIG is on the line not for $1 billion, but for $4 or $5 or $6 billion, however much it insured it for. So it allows people to insure for things that they don't have the offsetting liability for. And so you can imagine, some of these people-- if this guy fails will just take a loss and that's bad and all of the rest because they were expecting that they wouldn't-- but some of these players might have had offsetting hedges. The only reason why they might have felt comfortable taking on some other liability is they said, look, if the economy goes really bad, 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 say, hey, look, I'm 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, now all of a sudden this guy becomes insolvent. But this guy was dependent on this guy paying and he thought he was good because he even looked at this guy's books and said this guy had offsetting hedges, and now this guy might fail. And so you could have this entire cascade through the entire financial system.