If you want to know in detail what a CDS is and how it works, you can go to
http://en.wikipedia.org/wiki/Credit_default_swap. It is essentially financial insurance that is tradeable among the different players.
On how this has created a time bomb, I have included a good article below. Of course in the web there are many more good articles. Essentially, CDS is a derivative instrument and hence its nominal value has gone way way higher than the cash value of the debt it seeks to protect. I think easily 100X now. Since it is not traded on a regulated exchange and not regulated as an insurance product, there is substantial counter-party risks and may not have shown up in many banks' books. Most banks assume that they are well-protected with CDS; but if all hell break lose, they will find that they are in fact naked.
Between 2000 and 2007, the nominal value of CDS transacted has increased many fold to now about US$60 trillion. And a large chunk is in mortgages and banks. Now we are seeing real estate crashing and bank bankrupcies in the doves. Is it not a potential time bomb for holders of CDS, whether your position is long or short ?
Other than counterparty risk in a CDS, I have never believed in the concept of financial insurance. It does not make sense to me that credit risk can be arbitraged. For example, if you are DBS and you lent to SIA at 50 basis points above S$ SWAP. Say immediately, you are able to buy a CDS on SIA from UOB at say 30 basis points. This means you effectively yield 20 basis points on UOB risk when in the interbank market you yield zero spread from lending to UOB.
Historically, in the US, given its sophistication in the corporate debt market, CDS makes sense as they are priced to fill up the gap between the spot and swap pricing of a debt. As competition increases, CDS pricing did not make sense any more. But insurance companies, investment banks and hedge funds underwrire them because of the attractive premiums (basically greed) received upfront believing that the underwritten assets will not fail :- "It was like writing fire insurance, assuming no one is ever going to have a fire, only now they're turning around and watching as the whole town burns down."
Several years ago already, many insurance companies in the US were severely burnt by financial insurance products that they launched to bank customers. They think that like any other insurance products, they could manage credit risk based on "law of big numbers or large portfolio". In reality, the risks were not able to be modeled conventionally and they were severely burnt (in statistics, it means that outlier risks occur more often than you think). But there was no sysmetic risk on the financial system due to the fact that they were still regulated as insurance products (you need to provide reserves for them). With CDS, it is still financial insurance, but because of the way that they are structured they have missed regulation. So that is how we have ended up with all these shit. Again, basically greed.
Buffett's "time bomb" goes off on Wall Street
Thu Sep 18, 2008 1:42pm EDT Email | Print | Share| Reprints | Single Page | Recommend (251) [-] Text [+]
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¥ € $ - Learn. Practice. Trade.By James B. Kelleher - Analysis
CHICAGO (Reuters) - On Main Street, insurance protects people from the effects of catastrophes.
But on Wall Street, specialized insurance known as a credit default swaps are turning a bad situation into a catastrophe.
When historians write about the current crisis, much of the blame will go to the slump in the housing and mortgage markets, which triggered the losses, layoffs and liquidations sweeping the financial industry.
But credit default swaps -- complex derivatives originally designed to protect banks from deadbeat borrowers -- are adding to the turmoil.
"This was supposedly a way to hedge risk," says Ellen Brown, the author of the book "Web of Debt."
"I'm sure their predictive models were right as far as the risk of the things they were insuring against. But what they didn't factor in was the risk that the sellers of this protection wouldn't pay ... That's what we're seeing now."
Brown is hardly alone in her criticism of the derivatives. Five years ago, billionaire investor Warren Buffett called them a "time bomb" and "financial weapons of mass destruction" and directed the insurance arm of his Berkshire Hathaway Inc (BRKa.N: Quote, Profile, Research, Stock Buzz) to exit the business.
LINKED TO MORTGAGES
Recent events suggest Buffett was right. The collapse of Bear Stearns. The fire sale of Merrill Lynch & Co Inc (MER.N: Quote, Profile, Research, Stock Buzz). The meltdown at American International Group Inc (AIG.N: Quote, Profile, Research, Stock Buzz). In each case, credit default swaps played a role in the fall of these financial giants.
The latest victim is insurer AIG, which received an emergency $85 billion loan from the U.S. Federal Reserve late on Tuesday to stave off a bankruptcy.
Over the last three quarters, AIG suffered $18 billion of losses tied to guarantees it wrote on mortgage-linked derivatives.
Its struggles intensified in recent weeks as losses in its own investments led to cuts in its credit ratings. Those cuts triggered clauses in the policies AIG had written that forced it to put up billions of dollars in extra collateral -- billions it did not have and could not raise.
EASY MONEY
When the credit default market began back in the mid-1990s, the transactions were simpler, more transparent affairs. Not all the sellers were insurance companies like AIG -- most were not. But the protection buyer usually knew the protection seller.
As it grew -- according to the industry's trade group, the credit default market grew to $46 trillion by the first half of 2007 from $631 billion in 2000 -- all that changed.
An over-the-counter market grew up and some of the most active players became asset managers, including hedge fund managers, who bought and sold the policies like any other investment.
And in those deals, they sold protection as often as they bought it -- although they rarely set aside the reserves they would need if the obligation ever had to be paid.
In one notorious case, a small hedge fund agreed to insure UBS AG (UBSN.VX: Quote, Profile, Research, Stock Buzz), the Swiss banking giant, from losses related to defaults on $1.3 billion of subprime mortgages for an annual premium of about $2 million.
The trouble was, the hedge fund set up a subsidiary to stand behind the guarantee -- and capitalized it with just $4.6 million. As long as the loans performed, the fund made a killing, raking in an annualized return of nearly 44 percent.
But in the summer of 2007, as home owners began to default, things got ugly. UBS demanded the hedge fund put up additional collateral. The fund balked. UBS sued.
The dispute is hardly unique. Both Wachovia Corp (WB.N: Quote, Profile, Research, Stock Buzz) and Citigroup Inc (C.N: Quote, Profile, Research, Stock Buzz) are involved in similar litigation with firms that promised to step up and act like insurers -- but were not actually insurers.
"Insurance companies have armies of actuaries and deep pools of policyholders and the financial wherewithal to pay claims," says Mike Barry, a spokesman at the Insurance Information Institute.
"SLOPPY"
Another problem: As hedge funds and others bought and sold these protection policies, they did not always get prior written consent from the people they were supposed to be insuring. Patrick Parkinson, the deputy director of the Fed's research and statistic arm, calls the practice "sloppy."
As a result, some protection buyers had trouble figuring out who was standing behind the insurance they bought. And it put investors into webs of relationships they did not understand.
"This is the derivative nightmare that everyone has been warning about," says Peter Schiff, the president of Euro Pacific Capital at the author of "Crash Proof: How to Profit From the Coming Economic Collapse."
"They booked all these derivatives assuming bad things would never happen. It was like writing fire insurance, assuming no one is ever going to have a fire, only now they're turning around and watching as the whole town burns down."
(Editing by Andre Grenon)