The worst’s behind us? Think again
—Lily Tomlin
It was after midnight and I was about to go to sleep after a hard day’s work when there was a knock on the door. I peeped through the keyhole and there she was with her best smile on.
“Ready to go out for coffee,” she asked as I opened the door.
“Coffee? Now?” I asked.
“Yeah, you promised yesterday. Remember?”
“Oh yeah I did. But, must we head for a coffee shop now? I am tired and at any rate I make better coffee than they do.”
“I don’t mind it here either, so long as you tell me about credit default swaps (CDS).”
“You are such a pest,” I said, trying to look serious.
“So be it, now shoot.”
“Well, let me start at the very beginning. Sometime in 1994, the bankers of J P Morgan met for an offsite weekend at a tony resort in Florida. J P Morgan had invested in a lot of financial securities issued by governments and companies from all over the world. Regulation required them to put aside some money in case any of these investments went bust. This money hardly earned any return, something no good banker could stand. The team thus brainstormed on ways to obviate the risk of default in financial securities and free up the reserve money for investment. All that brainstorming led to the birth of a new concept - CDS (The Monster That Ate Wall Street, by Matthew Philips, Newsweek, September 27, 2008).”
“CDS is essentially a form of insurance in which the buyer of the swap makes a series of payments to the seller of the swap and in return has the right to a payoff if the financial security he has invested in defaults. It is akin to life insurance, at least in structure. Every year I pay a premium to the life insurance company and if something were to happen to me, my nominee, i.e. my mother, will get a certain amount of money. Similarly, in case of credit default swaps, the institution which had invested in financial securities bought a credit default swap from an institution selling it. It paid a regular premium to the institution selling the swap. In return, if there was a default on the financial securities that had been bought, the institution that had sold the swap would make good the losses,” I explained.
“Interesting. But, how is it related to the current financial crisis?”
“Well, banks and financial institutions simply loved the product. They no longer needed to keep as much extra money aside for the risk of default on financial securities they had invested in, as they needed to do earlier. They could simply buy a CDS and insure that risk away. Small wonder, the market for CDS was worth $100 billion by 2000 and had risen to $6.4 trillion by 2004. But that was small change compared with the virtual explosion that took place in the CDS market after that. And this is where the sub-prime story comes in… Hey, I forgot, I was to make you some coffee.”
“Forget the coffee. Just keep talking,” she said excitedly.
“Okay, we discussed how as interest rates started to fall, banks and independent home loan brokers began lending to individuals who wouldn’t have got a loan in the normal scheme of things. Banks securitised these loans away by issuing financial securities and selling them. One reason the Wall Street institutions and other investors bought these financial securities was the fact that they had good credit ratings. But the other major reason was that investors could simply buy a CDS protection on the financial securities they were investing in. And this led to the CDS market reaching a whopping $62 trillion towards the end of 2007. Currently, the market is estimated to be around $55 trillion. So the sub-prime home loan market fed on the fact that CDS protection could be bought on financial securities being issued on these loans.”
“I remember reading somewhere that the world’s largest insurance company, American International Group (AIG), was in trouble because of CDS. Is that right?” she asked.
“Yes, AIG made the mistake of equating CDS with normal insurance. It started to sell CDS on sub-prime and other kinds of securitised financial securities. At the peak, AIG held CDS worth $440 billion. Once sub-prime borrowers started to default on their equated monthly installments to repay their loans, investors who had invested in the securitised financial paper issued against these loans saw these securities turn worthless and landed up at the doors of the sellers of CDS to make good their losses. AIG was a big seller of CDS and soon realised that it was not in a position to pay up the losses other investors had suffered. So it defaulted on $14 billion of CDS it had sold to investors. This is when the US government stepped in to bail out AIG with a loan of $85 billion because if the insurer kept defaulting on CDS there would be bigger problems. Also, AIG just sold CDS and kept it on its books. Others in the business sold CDS protection and then further sold it off to other investors. So if an investment firm faces a default on its financial securities, it must first figure out who it needs to settle its losses with. It’s a complete mess out there.”
“So, AIG made the mistake of equating CDS with normal insurance?”
“Yes. An insurance company sells insurance profitably because not all the insured individuals turn up to demand payment at the same time. Let’s say I have bought a health insurance policy and fall ill during a particular year and file for a claim. There’s no saying you will also fall ill during the same year and file for a claim. But, the financial markets do not work like that. When things go bad, they go bad for a lot of people at the same time. And that is what happened with the CDS market.”
“But the numbers are huge!”
“They are huge because in order to buy a CDS on a financial security, you need not have invested in that financial security. You can just play on the fact that a particular financial security will go bad and hope to make some money on it. And that is what has happened. I could bet on whether you would crash your car next year and hope to make money on it (The $55 trillion question, by Nicholas Varchaver and Katie Benner, www.money.cnn.com). Hence, a financial security might be worth $1 million and CDS worth $10 million might have been sold on it. Typically, 10 CDSs were sold for each loan. A lot of hedge funds sold CDS protection to make what they thought would be easy money because no one expected such massive defaults. In the days to come, as more sub-prime borrowers default, CDS buyers would want their losses to be made good.
But a lot of CDS sellers, such as hedge funds, are simply not in a position to make good these losses if a lot of CDS buyers turn up at the same time. They might go bust or try to make good some of the losses by selling their investments in stock markets across the world. This might lead to stock markets falling even more because when concentrated selling happens, there are never enough buyers around. To give you a sense of proportion, the gross domestic product (GDP) of the United States is $13.8 trillion. The CDS market at $55 trillion is nearly four times the size of the US GDP. So even if 10% of the CDS go bust, there would be losses worth around $5.5 trillion for institutions that have bought CDS protection.So they will approach the CDS sellers to make good these losses. Will CDS sellers be in a position to make good these losses to institutions that bought the CDS protection? I doubt.”
“What a mess,” she said.
“Any more questions?” I asked.
“None for now. But I could do with some coffee.”
(The example is hypothetical)
k_vivek@dnaindia.net
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