Credit Default Swaps For Dummies

[Cees Binkhorst]

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Credit Default Swaps For Dummies
By Roosh

“If it doesn’t pass, then heaven help us all.”

Allow me to teach you what a credit default swap is and why it’s so
important to what is happening to the economy today.

Virgle Kent borrows $50 from me. I want to get insurance on his debt in
case he goes broke. I go to Roissy and say, “Hey, Virgle Kent owes me
$50. Can you insure that debt?”

“I’ll insure it if you pay me $4 a year,” Roissy says.

“Done!”

Roissy is betting that VK will pay me back, especially since he did his
homework by looking at VK’s credit rating and saw it was superb. Roissy
wrote me a credit default swap, an unregulated derivative invented in
1995 by JP Morgan.

Unfortunately Roissy has some problems with his business, and he no
longer even has $50 to pay me in case VK goes broke. The premiums I gave
him are long gone. Credit agencies notice this and tell Roissy to find
some cash or his credit rating goes down. Roissy is fucked because if
his credit rating goes down then he won’t be able to raise cash at good
rates to keep his business open (today’s large businesses need a
constant flow of credit to maintain operations). Sure enough his rating
gets killed and Roissy goes bankrupt.

Now I’m in trouble. The debt I had on my books that was insured is now
uninsured. The agencies look at my books and see I have this exposed
debt and they downgrade my ass. I have no choice but to enter bankruptcy
as well. But I happened to be knee deep in the CDS game too. I wrote a
ton of them for Arjewtino, insuring the debt owed to him by other
parties. When I go down it puts pressure on him. Like dominoes we fall.

In the carnage it turned out that the ratings we used to judge each
other’s debt worthiness was bogus from the start. Essentially we all
gambled like we would at a blackjack table, but we did it while drunk.
And blind.

The insurance company AIG wrote $78 billion worth of swaps.

Ivy League MBA’s turned the CDS into an even more insidious device. In
ways that I will not begin to understand, swaps were used not just to
insure against debt but to speculate if companies would fail or not. It
turned out that while VK only owed me $50, there were swaps written
worth $500 between parties that VK didn’t even know about! The swaps
became a means to make money instead of a simple insurance policy. This
was enabled by a government run by politicians whose treasure chests
were stocked full of kind donations from the big bankers. They did not
hesitate to look the other way.

A lot of swaps were written by banks and businesses that are now very
sick from making bad bets and possibly outright fraud in the housing
boom. (Who would have thought that giving no money down / no-doc loans
was a bad idea?)

Here’s the bad news:

     …there are $45 trillion of credit default swaps out there. A
default on a mere 10% would cause an economic disaster. Unfortunately,
it’s guaranteed to happen.

Actually that was the good news. Here’s the real bad news:

     The Bank for International Settlements recently reported that total
derivatives trades exceeded one quadrillion dollars – that’s 1,000
trillion dollars. How is that figure even possible? The gross domestic
product of all the countries in the world is only about 60 trillion
dollars. The answer is that gamblers can bet as much as they want.

The quote up top was said by Henry Paulson.

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