Credit Default Swaps are like a
car insurance. Instead of buying an insurance for a car you have bought,
you buy an insurance for a Bond you bought.
CDS are derivatives.
The total size of this market
is A STAGGERING $ 63 Trillion !
A premium is to be paid for the
risk. The higher the risk, the higher the premium. As an example - under
normal circumstances, the risk for a bond issued by the American
government is smaller than the risk of of bond issued by a company as
If the risk occurs - either the interest
or the Bond cannot be repaid, the damage is compensated by the Insurer.
Premiums are paid quarterly for the
term of the contract but decided upon at the moment the insurance is
underwritten. The higher the risk, the more expensive the premium.
Premiums for CDO's on Morgan Stanley
used to be 2% ..now they are 8% to 10%
Premium for CDO's on Washington
Mutual used to be 5% and spiked to 40%.
Premiums for Ford were 12% and they
spiked to 18%
GM premiums rose from 10% to 25%
One of the companies
which underwrote this kind of insurance (CDS) was AIG. They wrote credit
default swaps on the CDO subprimes, Lehman, and other financials that went
Domino...domino...House of cards: One of the major mistakes the
American authorities made was to let Lehman go bankrupt as this triggered
the payment of huge amounts by AIG and its own default.
Credit derivatives only
have 10 major players: one goes down and it affects the other 9 players
derivative insurers cannot be compared to life insures. The reason being
obvious: premiums in life insurance are calculated based on mortality
tables. People tend to live an average of so many years.
Credit Default Swaps
premiums are/were the result of an extremely narrow market, misallocation
of funds, abnormal low interest rates and abnormal low premiums. In good
times, when nothing happens, all insurers cash in the premiums and make a
lot of bucks. In bad times however, the whole sector suffers and the
default of one insurer can become dramatic for another insurer or
financial company: if the insurer of a Bond goes bankrupt, the Bond can
become insolvent and the financial company carrying it on his books
BASEL II regulations define how much capital banks must
maintain in reserve. Here starts the irony. This is based on the quality
of the bank's loan book. Unregulated Credit Default swaps allowed
banks to get around the Basel rules.
Because of a
booming Real Estate market, subprime securities were insured for
almost nothing. In those days, the risk of default of a mortgage was very
low and if it occurred, the value of the Estate was always high enough to
cover for the loss.
insurer (ex. AIG) did not have to put up any capital as collateral because
this kind of operation is not regulated. The only condition was to
maintain a triple A credit rating.
A computer model
decided about the premium, and profits could be booked as soon as the
swap was sold.
conditions, any bank could (over) leverage itself to the full extend
allowed under the Basel II regulations. The insurers could book millions
of profit each year without worrying about the collateral.
But the profits
which were booked never materialized and all of a sudden the default rates
on mortgages multiplied and this is how certain securities labeled AAA
were in fact worth less than $ 1...the end of the game!
The house of cards
collapsed and what we saw was domino...domino: AIG, Lehman, Merrill Lynch,
Goldman Sachs, ...a financial Tsunami!
Without the help of
Government, any major bank in the World would have gone bankrupt.
Without a credit
default market NO bank can report the correct state of its assets.
Without a credit
default market all banks would fail the Basel II regulations.
Replacing this massive
credit creating machine will lead us straight into Hyperinflation and a
deep depression. No doubt about this!
The purpose for big
bailouts was to prevent CDSwap explosions, risking a string of bombs to go
off. The key aspect of CDSwap contracts is their hidden nature, with fuses
intersecting in the dark.
The Credit Default
Swaps are capable of burning Hiroshima holes all over the US financial
system, resulting in US Economic implosion from eliminated bank and
financial system structures almost entirely. The process has only begun,
but in darkness.
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