Can someone explain Credit Default Swaps / derivatives to me?

[nano1895]

And how they related to the housing bubble? And how (if they are) connected to the Federal Reserve / government policy. I want to be well informed because a few people on facebook are now posting about it and saying the usual "we need more regulation / unregulated capitalism doesn't work" and I'm sure that government policy and the federal reserve were also primary culprits. So before I dive into those wall o text back and forths I want to have all my ammo with me


Edit: and ofc slowly direct them towards RP, that's the ultimate goal here

 

[onlyrp]

it's true we need more anti-fraud regulation and less bailouts. Some will say anti-fraud is not really a regulation.

 

[SilentBull]

Here you go:

 

[thoughtomator]

A credit default swap is a risk management device that functions like an insurance policy against an investment (e.g. a bond). It is used to hedge the default risk in the bond.

In the aggregate, however, credit default swaps are a suicide pact/hostage situation, as they create a chain of economic ties throughout the financial system that insures that the detonation of any sizeable institution will blow up more and more institutions back up the CDS daisy chain, wrecking all the financial institutions and the CDS holders don't get fully paid, either. It is the reason for the "tanks in the streets" threat of Hank Paulson when he demanded Congress pass the TARP bailout. The argument for the bailout was basically that the interconnectedness (in no small way through CDS) of the financial system made certain "systemically important" institutions "too big to fail".

The reason why this happens is that sellers of CDS very rarely hold onto that risk, they pass it on to hedge their own risk, and so on down the line until no one can be found to hold the financial bomb it represents. If the contract expires and the insured security didn't blow up, then all is good. If the security did blow up, then the CDS seller has to pay out in a big way. If they just don't have the money (and few do), then the CDS seller blows up, and then everyone who wrote CDS against that company has to pay up, and so on and so forth.

The chaining of risk works like this:

Bondholder hedges his risk by buying a CDS from Bank A
Bank A buys a CDS from Bank B at a slightly lower price, pawning off the risk and pocketing the difference as free money.
Bank B buys a CDS from Bank C, as above.
Bank C buys a CDS from Bank D, as above.
Bank D buys a CDS from Bank E, as above.
Bank E buys a CDS from Bank F, as above.
Bank F buys a CDS from Bank G, as above.
Bank G can't find a CDS seller at a lower price and is stuck with the net liability should the security default.

Now the security defaults.

Bondholder goes to Bank A and says "pay up".
Bank A goes to Bank B for the money to pay Bondholder, as per the terms of the CDS.
Bank B goes to Bank C for the money to pay Bank A, as above.
Bank C goes to Bank D for the money to pay Bank B, as above.
Bank D goes to Bank E for the money to pay Bank C, as above.
Bank E goes to Bank F for the money to pay Bank E, as above.
Bank F goes to Bank G for the money to pay Bank E, as above.

But Bank G doesn't have it. Barring intervention, Bank G goes tits up.

Bank G going tits up means Bank F is now on the hook for the CDS they wrote - and they didn't expect to be since their paper risk was a technical zero (according to a badly flawed, but quite popular theory).
Bank F doesn't have the money, so they go tits up, leaving Bank E on the hook.
Bank E doesn't have the money, so they go tits up, leaving Bank D on the hook.
Bank D doesn't have the money, so they go tits up, leaving Bank C on the hook.
Bank C doesn't have the money, so they go tits up, leaving Bank B on the hook.
Bank B doesn't have the money, so they go tits up, leaving Bank A on the hook.
Bank A doesn't have the money, so they go tits up, and Bondholder doesn't get paid, and any number of banks were just wiped off the face of the planet.

 

[The Gold Standard]

This is a perfect example of how destructive the Fed's endless easy credit policies and fractional reserve banking are. If these banks had to have real money from someone's savings stored in their vaults in order to buy these instruments, there wouldn't be enough money and very limited demand for them. Another thing that would crush the demand for them is the banks would only lend the money to creditworthy borrowers if their asses were on the line. Without so many bad loans there wouldn't be the need for endless insurance on the loans.

Anyone who thinks regulations will solve the problem are fooling themselves. As long there is an endless supply of money and credit available to the banks, they will find something to invest it in, no matter who is regulating them, and as a result cause chaos in the economy.

The simple solution is to abolish the central bank, use real money, and require 100% reserve banking. Any banks that can't redeem customer deposits should be prosecuted for fraud.

 

[nano1895]

This is a perfect example of how destructive the Fed's endless easy credit policies and fractional reserve banking are. If these banks had to have real money from someone's savings stored in their vaults in order to buy these instruments, there wouldn't be enough money and very limited demand for them. Another thing that would crush the demand for them is the banks would only lend the money to creditworthy borrowers if their asses were on the line. Without so many bad loans there wouldn't be the need for endless insurance on the loans.

Anyone who thinks regulations will solve the problem are fooling themselves. As long there is an endless supply of money and credit available to the banks, they will find something to invest it in, no matter who is regulating them, and as a result cause chaos in the economy.

The simple solution is to abolish the central bank, use real money, and require 100% reserve banking. Any banks that can't redeem customer deposits should be prosecuted for fraud.

Thanks everyone for their answers, I'm understanding this much better now, especially with that video. In prosecuting fraud, would that be one of the proper roles of the federal government?

 

[The Gold Standard]

Thanks everyone for their answers, I'm understanding this much better now, especially with that video. In prosecuting fraud, would that be one of the proper roles of the federal government?

Not really. But it would be a proper role of state governments, at least according to the Constitution. I suppose if people were defrauded across several states it could be argued it should be handled in federal courts. Either way, the law should be enforced.

 

[SeekingFreedom]

Easiest way to understand CDS is that it is essentially insurance on a loan.

i.e. Goldman Sachs has mortgaged backed security, they buy some CDS from AIG. GS pays a premium. If the loans in the MBS go bad then AIG has to pay the value of the MBS to Goldman Sachs.

CDS aren't necessarily a bad thing, but AIG had no real collateral or reserves to pay out all their CDS, which is why they should've gone broke instead of getting a bailout.

 

[Indy Vidual]

Some derivatives were so new that there simply was no regulation or 'related laws.'
The total $$$ value of all derivatives is so HUGE....
...this amazing true story will continue to unfold in the near future.

 

[kylejack]

Put simply, a credit default swap is basically an insurance policy for an investment (such as a bond made up of homeowner mortgages, as the most relevant example), sold by insurers like AIG. Except it isn't technically insurance, so it wasn't subject to all of the regulations associated with insurance, and things like reserve requirements (insurers must have a certain % of cash on hand of what they're insuring...but with CDS there was no restriction whatsoever).

Anyone could buy this de facto insurance policy, even if they didn't own the asset, and sometimes hundreds of people did own the same CDS. Imagine if hundreds of people held an insurance policy on your car. If you wreck your car, they all get paid the value of your car, or close to it. Your $20,000 car is now a $500,000 liability for the insurer. And actually, many of those people that bought the insurance policy knew you were going to wreck your car, because they're the ones that built your defective car.

But how did AIG get suckered into it? Well, the bond rating agencies were bribed by the bond companies. AIG thought it was insuring AAA bonds. If a few fail, no big deal, they're making tons of money on the others, right? Except a metric shitload of them failed, because those AAAs were actually junk bonds full of mortgages for people who had no business getting a mortgage.

 

[kylejack]

And if you want to see what was driving this whole monster, this is a great summary.

 

[Aurave]

Merely one simple of many examples of how investment banks win on mortgage derivatives due to government policy and intervention:

Buy a pool of (implicitly government backed) conventional mortgages from a GSE such as Fannie.
Buy a pool of subprime mortgages from a private entity such as Countrywide.

Separate them each into interest and principal payment strips. Combine the higher yield and riskier interest strip from the subprime mortgages, with the principal strip from the conventional mortgage from Fannie.

Now you have a AAA investment grade product to sell, with a junk bond level of return on some components yet other components that are backed by the full faith and credit of the United States government.

Basically the government messes up markets, almost always does. This guarantee of Freddie and Fannie led to market distortions by greatly increasing the demand coming from investment banks for subprime mortgages they could create derivatives with once they figured out how they could make use of government intervention. Companies like Countrywide stepped up to the plate and increased the supply of those subprimes for all that demand, by saying f*** it to lending standards and creating as many subprime mortgages as they could. And people that had no business buying a $500k home with no money down on a $35k yearly salary stepped up and couldn't really pass on a "free" house that would pay for itself.


I place a modicum of blame on each of part of that chain of course. Some more than others, but I want to get at the actual root cause. I don't place the blame entirely on poor people, or stupid people, as the rhetoric of certain "I hate everyone" conservatives seems to be. And unlike those well meaning "I'm not a socialist I just advocate socialist policy" liberals, I don't place the entire blame of the system on companies like Countrywide, who really just filled a demand in their market. I don't really even blame the giant financial institutions for creating these products, as much as everyone loves to hate them. We should be neither surprised nor outraged when we as a people, as a government, incentivize events and behavior with completely predictable outcomes. If you keep going up the root chain, you see the problem is government; a government that promises to pay for the risks of capitalism and by doing so destroying it in the process.

I hope that whole thing wasn't repetitive tautology or a useless rant. I'm not one to edit posts, but perhaps a few of my words will be helpful to you.

 

[nano1895]

Merely one simple of many examples of how investment banks win on mortgage derivatives due to government policy and intervention:

Buy a pool of (implicitly government backed) conventional mortgages from a GSE such as Fannie.
Buy a pool of subprime mortgages from a private entity such as Countrywide.

Separate them each into interest and principal payment strips. Combine the higher yield and riskier interest strip from the subprime mortgages, with the principal strip from the conventional mortgage from Fannie.

Now you have a AAA investment grade product to sell, with a junk bond level of return on some components yet other components that are backed by the full faith and credit of the United States government.

Basically the government messes up markets, almost always does. This guarantee of Freddie and Fannie led to market distortions by greatly increasing the demand coming from investment banks for subprime mortgages they could create derivatives with once they figured out how they could make use of government intervention. Companies like Countrywide stepped up to the plate and increased the supply of those subprimes for all that demand, by saying f*** it to lending standards and creating as many subprime mortgages as they could. And people that had no business buying a $500k home with no money down on a $35k yearly salary stepped up and couldn't really pass on a "free" house that would pay for itself.


I place a modicum of blame on each of part of that chain of course. Some more than others, but I want to get at the actual root cause. I don't place the blame entirely on poor people, or stupid people, as the rhetoric of certain "I hate everyone" conservatives seems to be. And unlike those well meaning "I'm not a socialist I just advocate socialist policy" liberals, I don't place the entire blame of the system on companies like Countrywide, who really just filled a demand in their market. I don't really even blame the giant financial institutions for creating these products, as much as everyone loves to hate them. We should be neither surprised nor outraged when we as a people, as a government, incentivize events and behavior with completely predictable outcomes. If you keep going up the root chain, you see the problem is government; a government that promises to pay for the risks of capitalism and by doing so destroying it in the process.

I hope that whole thing wasn't repetitive tautology or a useless rant. I'm not one to edit posts, but perhaps a few of my words will be helpful to you.

no no no all of these explanations have been extremely helpful

 

[Travlyr]

Sure. I steal from you legally. You have NO recourse. I have Johnny Law on my side and he has guns... even nuclear weapons if necessary... and free media time.

 

[Jordan]

I just wanted to add a few things to this discussion. There are several great responses, especially Aurave's, which hits on the key point of turning junk into AAA-rated debt obligations. This is key to the institutional effect in economics. Most pensions and retail investment funds can only own AAA-rated debt. As a result, there was incentive to turn almost every debt instrument into an AAA-rated security with credit default swaps.

It's important to say that derivatives are not inherently bad. In fact, they're actually quite good; they provide liquidity for risk management that might not otherwise exist. Your car insurance, for example, is a derivative. Automotive insurance companies cannot short sell your car to hedge themselves against the risk of damages to your car.

The problem with derivatives is government. Regulations ensure that only the biggest investment banks can participate in the derivatives market, and thus the risk of almost every financial event is borne by only a small sample of all market actors.

The Dodd-Frank bill is a great example of a bill that further "regulated" derivatives only to make derivatives more dangerous. Before Dodd-Frank, American investors could buy derivatives (loosely defined as an over-the-counter transaction) on spot gold, silver, and foreign currency on margin through whichever broker they would like. Today, these trades are outlawed for retail investors.

There was no change to the speculative positions of institutional investors in the derivatives market as it relates to gold, silver, or currencies. So, thanks to recent regulation, you have fewer people participating in what should be an efficient market. You can't have efficient markets with fewer market participants.

In a world without excessive regulation, the derivatives market would be as competitive, transparent, and virtually as riskless as the automotive insurance market. The problem is that only a few banks are legally allowed to participate, and thus a few trading desks bear the full risk of financial catastrophe. Each year, thousands of cars are wrecked, property and casualty companies pay out billions for home repairs, and people feel as if the end is nigh with each natural disaster. But because each company has robust competition in each space, and often reinsurance from several other firms, the risk is spread so thin that hardly any insurance companies go bankrupt in any given year.

 

[Jordan]

Dodd-Frank has cost me tens of thousands, if not hundreds of thousands of dollars. I hate that bill.

I love how it "regulated derivatives" to the extent that it gave a virtually monopoly to a few select firms in the retail space while limiting the amount of leverage available to retail investors. Scumbag Congress: Regulates derivatives; exempts the banking cartel.

 

[William R]

bump

 

[osan]

A credit default swap is a risk management device that functions like an insurance policy against an investment (e.g. a bond). It is used to hedge the default risk in the bond.

In the aggregate, however, credit default swaps are a suicide pact/hostage situation, as they create a chain of economic ties throughout the financial system that insures that the detonation of any sizeable institution will blow up more and more institutions back up the CDS daisy chain, wrecking all the financial institutions and the CDS holders don't get fully paid, either. It is the reason for the "tanks in the streets" threat of Hank Paulson when he demanded Congress pass the TARP bailout. The argument for the bailout was basically that the interconnectedness (in no small way through CDS) of the financial system made certain "systemically important" institutions "too big to fail".

The reason why this happens is that sellers of CDS very rarely hold onto that risk, they pass it on to hedge their own risk, and so on down the line until no one can be found to hold the financial bomb it represents. If the contract expires and the insured security didn't blow up, then all is good. If the security did blow up, then the CDS seller has to pay out in a big way. If they just don't have the money (and few do), then the CDS seller blows up, and then everyone who wrote CDS against that company has to pay up, and so on and so forth.

The chaining of risk works like this:

Bondholder hedges his risk by buying a CDS from Bank A
Bank A buys a CDS from Bank B at a slightly lower price, pawning off the risk and pocketing the difference as free money.
Bank B buys a CDS from Bank C, as above.
Bank C buys a CDS from Bank D, as above.
Bank D buys a CDS from Bank E, as above.
Bank E buys a CDS from Bank F, as above.
Bank F buys a CDS from Bank G, as above.
Bank G can't find a CDS seller at a lower price and is stuck with the net liability should the security default.

Now the security defaults.

Bondholder goes to Bank A and says "pay up".
Bank A goes to Bank B for the money to pay Bondholder, as per the terms of the CDS.
Bank B goes to Bank C for the money to pay Bank A, as above.
Bank C goes to Bank D for the money to pay Bank B, as above.
Bank D goes to Bank E for the money to pay Bank C, as above.
Bank E goes to Bank F for the money to pay Bank E, as above.
Bank F goes to Bank G for the money to pay Bank E, as above.

But Bank G doesn't have it. Barring intervention, Bank G goes tits up.

Bank G going tits up means Bank F is now on the hook for the CDS they wrote - and they didn't expect to be since their paper risk was a technical zero (according to a badly flawed, but quite popular theory).
Bank F doesn't have the money, so they go tits up, leaving Bank E on the hook.
Bank E doesn't have the money, so they go tits up, leaving Bank D on the hook.
Bank D doesn't have the money, so they go tits up, leaving Bank C on the hook.
Bank C doesn't have the money, so they go tits up, leaving Bank B on the hook.
Bank B doesn't have the money, so they go tits up, leaving Bank A on the hook.
Bank A doesn't have the money, so they go tits up, and Bondholder doesn't get paid, and any number of banks were just wiped off the face of the planet.

Good job. I will add that the foundational problem here is the lack of proper security. The banks and other issuing institutions were not required to hold the proper means of securing the policies, which is to say cash and cash equivalents. What good is it to you if I write you a policy but have no funds to pay up when the music stops? That is EXACTLY what happened.

Now, we must also recognize the other side of the problem that no amount of regulation would have prevented: collapse en masse of the market. Even if the CDSs issued had all been properly secured and only one layer deep, vis-a-vis "bundled" or "repackaged" as per above, the near utter collapse of the market guaranteed the failures. Insurance companies survive because the structure of their business is based on a set of presumptions pursuant to "mean" outcomes. In this case, mean denotes the typical rate of periodic (yearly?) failures resulting in claims for which the company would be liable. So long as the premiums taken in sum to more than the claims paid, the company remains in business. So the problem of market bubbles can be seen to underpin this sort of trouble. It was the market bubble, which was destined to fail, that guaranteed that disaster would ensue. It was the market equivalent of the earthquake or massive hurricane.

Extraordinary events threaten a company's survival. Katrina basically destroyed the city of New Orleans substantially. That is the sort of extreme and concentrated loss that can put an insurance company out of business because of the requirement to pay staggering sums all at once. This is precisely the sort of event the markets experienced. No matter how well secured the policies may have been, the sheer mass of the loss virtually guaranteed that many issuers would go TU. The fact that these securities were repackaged many times over constituted de-facto leverage that works well enough in the absence of catastrophe but in its presence amplifies the failure greatly.

Do we need more regulation? I would say no. Fraud law is well established, so the regulation is there. What we DO need is more transparency, IMO and that is something that should really be a matter of market force and not that of government. If people are willing to invest ignorantly then I see no problem with companies taking their money. If they want sound investment, they have to demand it; but that necessitates enough knowledge to understand what "sound" means. People invest ignorantly and with great avarice, expecting unreasonable returns on investment. CDSs are an example of this. One buys a security and then an insurance policy in an attempt to wipe all risk away. How stupid is this? My investment earns x% and my insurance policy costs me y%. Depending on the spread between the earnings of x and the cost of y, chances are pretty good that I could have just gone with another, far more safe investment earning z% whose annual yield would be either close to or even greater than the superficially more attractive security.

People do not understand cost/benefit, opportunity cost, risk, related rates, etc. Yet they venture forth as the great traders and big shots, then whine like little spoiled children when the predictable adverse consequences are realized. Free markets are risky affairs, as is freedom in general. Far too many people have been seduced by the lie that they can have their cakes and eat them too. There are NO free lunches. Anywhere. Anytime. By any means. Ever. Period. Kaput. Until people pull their heads from their assholes, they will continue to get fleeced by the unscrupulous who promise heaven amidst the consuming flames of damnation. This is precisely why the socialistic agendas of communism and the progressives have been so wildly successful - something for nothing. Works every time.

 

[thoughtomator]

What we really need is prosecution of the in-your-face crimes from the Wall St. and DC crowd. But who is going to prosecute when the government is owned and operated by the crooks?

 

[Paul Or Nothing II]

And how they related to the housing bubble? And how (if they are) connected to the Federal Reserve / government policy. I want to be well informed because a few people on facebook are now posting about it and saying the usual "we need more regulation / unregulated capitalism doesn't work" and I'm sure that government policy and the federal reserve were also primary culprits. So before I dive into those wall o text back and forths I want to have all my ammo with me


Edit: and ofc slowly direct them towards RP, that's the ultimate goal here

Assumption are usually not a good bet but you've chosen wisely

Many others have already done a very good job explaining the many aspects of the crisis; I'll just like to add the systemic role of "corporate personhood" & "limited liability", which allows companies to take risks that they otherwise wouldn't take These are government protections to companies that are a surreptiously cause of fraud & irresponsibility

In a free market, INDIVIDUALS are expected to be responsible for their actions, not fictitious entities like "legal person" with limited libility, which means that if a company goes down then the people running that company are held DIRECTLY responsible for the company, which means if the company's assets are insufficient to pay off its obligations then the PERSONAL PROPERTY of those running the company will be used to pay off all the bereaved parties! Now, that would be a significant deterrent for companies to NOT take the kind of risks they take, not to mention, there'd be no need for bailouts either, but again, it's the government that protects companies & those running it thru its laws & regulations whereas in a free market, they'd be held responsible for their actions

It's something to think about, would companies be taking the kind of risks they sometimes take, if the PERSONAL PROPERTY of those running them was on the line? I don't think so! They take such risks sometimes because they know they'll be able to make huge money by taking such risks & get handsome salaries & bonueses & what not while everything is going up & even if it doesn't work out, they won't have to share the losses!

This is a perfect example of how destructive the Fed's endless easy credit policies and fractional reserve banking are. If these banks had to have real money from someone's savings stored in their vaults in order to buy these instruments, there wouldn't be enough money and very limited demand for them. Another thing that would crush the demand for them is the banks would only lend the money to creditworthy borrowers if their asses were on the line. Without so many bad loans there wouldn't be the need for endless insurance on the loans.

Anyone who thinks regulations will solve the problem are fooling themselves. As long there is an endless supply of money and credit available to the banks, they will find something to invest it in, no matter who is regulating them, and as a result cause chaos in the economy.

The simple solution is to abolish the central bank, use real money, and require 100% reserve banking. Any banks that can't redeem customer deposits should be prosecuted for fraud.

+1

I just wanted to add a few things to this discussion. There are several great responses, especially Aurave's, which hits on the key point of turning junk into AAA-rated debt obligations. This is key to the institutional effect in economics. Most pensions and retail investment funds can only own AAA-rated debt. As a result, there was incentive to turn almost every debt instrument into an AAA-rated security with credit default swaps.

It's important to say that derivatives are not inherently bad. In fact, they're actually quite good; they provide liquidity for risk management that might not otherwise exist. Your car insurance, for example, is a derivative. Automotive insurance companies cannot short sell your car to hedge themselves against the risk of damages to your car.

The problem with derivatives is government. Regulations ensure that only the biggest investment banks can participate in the derivatives market, and thus the risk of almost every financial event is borne by only a small sample of all market actors.

The Dodd-Frank bill is a great example of a bill that further "regulated" derivatives only to make derivatives more dangerous. Before Dodd-Frank, American investors could buy derivatives (loosely defined as an over-the-counter transaction) on spot gold, silver, and foreign currency on margin through whichever broker they would like. Today, these trades are outlawed for retail investors.

There was no change to the speculative positions of institutional investors in the derivatives market as it relates to gold, silver, or currencies. So, thanks to recent regulation, you have fewer people participating in what should be an efficient market. You can't have efficient markets with fewer market participants.

In a world without excessive regulation, the derivatives market would be as competitive, transparent, and virtually as riskless as the automotive insurance market. The problem is that only a few banks are legally allowed to participate, and thus a few trading desks bear the full risk of financial catastrophe. Each year, thousands of cars are wrecked, property and casualty companies pay out billions for home repairs, and people feel as if the end is nigh with each natural disaster. But because each company has robust competition in each space, and often reinsurance from several other firms, the risk is spread so thin that hardly any insurance companies go bankrupt in any given year.

This is true I see a lot of people who don't understand derivatives have become anti-derivative after the crisis but as explained above, derivatives are an important part of the markets but problems arise as usual when government distorts the markets with their (supposedly) well-intentioned "regulations" & interventions