Friday, October 1, 2010

Credit Default Swaps

No doubt you’ve heard of this arcane Wall St. term in the discussion of all the bailouts and related issues to our ongoing nationwide financial crisis.
I still don’t understand them and probably don’t need to but am reading an article by Matt Taibbi in Rolling Stone about how these figure into the Gulf Oil spill and BP’s financial condition

I’ve never been a gambler beyond a penny-ante poker game here and there with my Texas buds but I do know that in Vegas you can bet on anything. In sports it is common not just to bet on winners but on who will lose and by how much.

As much as my simple brain can figure, a credit default swap (CDS) is a “bet” on whether a company might be able to pay back all their debt. Seems companies have their own CDS scores similar to our personal credit ratings.

The worse a company is doing, the more likely they might NOT be able to pay back their debt so buying a CDS on their debt costs more. Are you with me so far?

Seems as things got worse with BP; the price of their CDS went up dramatically.

Doesn’t this whole thing sound bizarre? People bet huge sums of money on whether a company will fail and not be able to repay their debt? For the life of me this doesn’t make any sense but then I don’t have an MBA nor have I ever worked on Wall St.

Here’s where things get even weirder. We’ve all heard “too big to fail.”

Let’s say BP owed $1 billion (don’t they wish! But for my example let’s use this small round number.) But that liability is not pegged to how much BP actually owes. If their scores are high enough and their failure seemed likely, thousands of “bettors” could wager on their failure. And the amount of those wagers could top that $1 billion many times over. So even though they are betting on BP failing to pay off, the regulators, Govts. – whoever – are worried about not only just BP but all people whose fortunes many now be tied to them through something as simple and complex as a CDS.
Some CPA et al may quibble with my simplified explanation but I think I have the essence.

People are worried about foreclosures, their jobs, how to make ends meet and a bunch of Wall St. quants (this may or not be a pejorative!) are manipulating the system to create all sorts of schemes to make more money with what appears to be very little oversight and regulation.

This is where I have never understood (my fellow) Republicans resistance to do something to reform the entire financial industry. These CDS-things seem like a good place to start. They have rules in gambling to (at least try) to keep the house honest.

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