Tuesday, September 30, 2008

All about CDSs

Good article explaining credit default swaps - what they are, how they work, how many there are (see graph above), the danger they represent, etc. Some choice quotes:
  • "... CDS are easy to create: Often deals are done in a one-minute phone conversation or an instant message. Many technical aspects of CDS, such as the typical five-year term, have been standardized by the International Swaps and Derivatives Association (ISDA). That only accelerates the process. You strike your deal, fill out some forms, and you've got yourself a $5 million - or a $100 million - contract..."
  • "... You can guess how Wall Street cowboys responded to the opportunity to make deals that (1) can be struck in a minute, (2) require little or no cash upfront, and (3) can cover anything. Yee-haw! You can almost picture Slim Pickens in Dr. Strangelove climbing onto the H-bomb before it's released from the B-52. And indeed, the volume of CDS has exploded with nuclear force, nearly doubling every year since 2001 to reach a recent peak of $62 trillion at the end of 2007, before receding to $54.6 trillion as of June 30, according to ISDA..."
  • "... But traders say almost no new contracts are being written on any but the most liquid debt issues right now, in part because nobody wants to put money at risk and because nobody knows what Washington will do and how that will affect the market. ("There's nothing to do but watch Bernanke on TV," one trader told Fortune during the week when the Fed chairman was going before Congress to push the mortgage bailout.) So, after nearly a decade of exponential growth, the CDS market is poised for its first sustained contraction..."
Here's what this blogger doesn't understand in this scenario.... The big issue right now is that the credit market is "clogged." Banks are not lending, not to each other, not to businesses that need the money for growth, etc., etc. However, where is all the money that was going into these instruments? It's all being held as banks, institutions, etc. are scared of taking any risks and want to keep liquid... It's not the fact that they loaned money like drunks to anyone with a pulse (and even some without) that is causing the current credit "clog" problems, it's the fact that they have a hangover and have suddenly turned parsimonious and are hanging on tightly to their money and not loaning it to good prospects!! Possibly this is a ridiculously silly suggestion (otherwise surely someone would have suggested this), but perhaps the government intervention shouldn't be on the "back end" (i.e. helping the financial companies clean up their toxic waste), but on the "front end" i.e. some sort of guarantee of all new loans struck provided they meet certain criteria...

The $55 trillion question