Wednesday, June 1, 2011

A Brief but Terrifying Description of Credit Default Swaps

Mountain climbers frequently rope themselves together, so that if one slips, the other members of the group can arrest their fall.

The idea is to transfer risk from one individual who is momentarily slipping to a group of stable climbers. This strategy often works well. But what happens if another person in the party does not have a sure footing at the moment that one member slips? Then we see tragic headlines such as this: Roped-Together Climbers Die in Fall On Mount McKinley in Denali National Park

This is not unlike a credit default swap (CDS), in which the risk of credit default is transferred from an individual creditor to a group of stable creditors. The danger, however, is that a default might occur when the rest of group does not have a sure footing. If that happens, the entire group goes down.

With CDSs, the debtor does not need to default in order for the group to go down. It could be something as simple as one member of the group going bankrupt for some unrelated reason. The risk that that member of the group had been shouldering is now transferred to the remaining members of the group. Another member of the group might not be in a position to take on that added risk, and that might pull them over the brink, which would transfer even more risk to the group's remaining members. With that, the entire group could go down.

(With this in mind, I am still trying to figure out how CDSs are supposed to make markets more stable, like the financial geniuses and their followers have been telling us.)

The Invisible Bubbles of Mass Destruction
CDSs are traded over-the-counter (OTC), in the absence of clearing houses. So CDS "market" has no regulation or visibility. As Ron Hera points out in this article for Seeking Alpha:

In OTC markets, counterparty default risk generates a network of interdependencies among market actors and promotes risk volatility. The resulting emergent property of the financial system is systemic risk, which became apparent in 2008 when Lehman Brothers Holdings, Inc. (LEHMQ.PK) failed.

It is not that derivatives caused Lehman's collapse, but they sure made a mess afterwards for those firms who were tied to Lehman. That is why we see headlines like this from Business Week: Lehman: One Big Derivatives Mess

No wonder that the boring, old finger wagger from Omaha called derivatives "weapons of mass destruction".

In order for a financial bubble to form, you need three things:
  1. Financial innovation -- such as the creation of mortgage-backed securities, for example
  2. Widespread adoption of that innovation -- the innovation goes "mainstream"
  3. Leverage -- purchase multiples of these innovations on margin
It is difficult for bubbles to form in the physical precious metals market, because when you are buying physical metal, there are no financial innovations (gold is just a barbarous relic, after all), and thus there is no widespread adoption of financial innovation. You can use margin when buying physical metal (that is what the Hunt Brothers did), but if you want to use some real leverage, you need to be buying paper, not metal. In fact, for some real adventures in leverage, try buying paper on top of paper and then transfer portions of the risk amongst a group. Now we are talking bubbles on a planetary scale.

Credit Event Horizon
The emergent danger of CDSs explains why the International Monetary Fund and the European Central Bank are so insistent that Greece must not default. They are desperately trying to avoid a credit default swap trigger. The default of a relatively small member of the European Union has the potential to pull banks and nations over the brink with it.

The solution that the financial elite proffer, of course, is to have the IMF and the central banks rush in with loads of money that they conjure out of thin air and loan to any financial institution or nation that is teetering. This costs nothing (because the principal was created out of nothing) and enables the financial elite to enslave the institution or nation under mountains of new debt. Kinda makes the protests in Ireland, Spain, and Greece take on new meaning, doesn't it?

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