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Credit Default Swaps
Posted by: McQ on Tuesday, September 30, 2008

Here's a pretty good explanation of some of the problems facing the financial markets today and some insight into why the proposed bailout's structure isn't likely to do much good.
Starting back in 1995, the masters of the bond and credit market universe got too cute by half and structured a new and exciting financial instrument, the credit default swap and it's these credit default swaps that are the crux of the problem. The magnitude of the fallout from this hairy piece of "financial engineering" is staggering. Believe me, when I tell you that these things are so wrapped around the axle I don't think anyone knows who's got what.

Under a CDS, a bank originates loan to a company. A second bank (or other financial institution) can agree to cover the credit risk for the loan, by agreeing to make payment to originating bank if the company defaults on the original loan. The originating bank pays a small insurance premium to the second bank for assuming the risk of the loan.

Typically, payments under a CDS would only be triggered by the company’s failure to pay interest or principal on its debts due to bankruptcy or some other severe liquidity issue. But there are a host of intermediate or special cases that will doubtless provoke lawsuits when something goes wrong (CDS being a new market, it is by no means "recession-proof").

Credit default swaps were sold to the world as hedging transactions. Investors were told that they were simply transfers of risk, so that banks that made loans could transfer credit risks to insurance companies, which did not make loans directly, or to foreign banks that could not easily make loans in the U.S. market.

But they didn't work out that way...
RTWT. Money quote (pun intended) and what we've all been saying for quite some time now:
I'm also a free market trader and believe that the market has to work this out. These type of bailout programs just tend to delay the pain and there is going to be some pain, my friends. I oppose the structure of this bailout on principle, so watching these government types preening and posturing in front of the cameras this weekend was like watching a train wreck in slow motion. They are beyond clueless.
That cluelessness is much more frightening, at least to me, than letting the markets have their way.

(HT: Wolf Howling)
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Previous Comments to this Post 

I think I see. Bank A makes a loan, and gets bank B to insure it. Bank B, not wanting to see its *ss waving in the wind, insures its risk with bank C. C does likewise with D, and D insures its risk with A. The circle jerk now being complete, all the executives retire to their cigar clubs to brag about their cleverness and the bonuses they have earned.
Written By: timactual
URL: http://
The CDS market is why AIG was rescued. They insured mortgage backed securities and other obligations around the world. Sadly they held no real reserves against possible losses (. Thus, when they and their supposed AAA credit rating went south institutions all over the world carrying various credit instruments at face value because they were insured by AIG suddenly would have to explain to regulators what the true value of those holdings were. A nightmare scenario for the Fed and even more importantly, European Central Banks.

That in the wake of that European officials had the gall to criticize American regulation given their banks shoddy accounting and extreme leverage is breathtaking if typical.
Written By: Lance
Isn’t the main problem that 3rd parties can buy and sell as many of these as they like? Which means a lot of bets on a company’s solvency...

Plus, people were using these as alternative measure to the credit ratings?
Written By: Harun
URL: http://

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