Thursday, October 23, 2008

Paddy Hirsch talks credit default swaps

Video from American Public Media's show Marketplace:

Untangling credit default swaps from Marketplace on Vimeo.

It's a doozy, that credit default swap biz. Things go swimmingly as long as they swim. But the credit downgrade twist where a company like AIG has to up its collateral against its obligations when it's perceived to be in trouble is crucial. Once the decline begins for a company that's too deep into CDSs, the outcome is pretty much a "slam dunk," so to speak.

And the option to bet against an insurable item -- corporate bonds in Hirsch's example -- is a major shitpile. You can legally buy a swap which guarantees the value of debt instruments to which you have no real exposure. That is, you can buy a guarantee that you will be compensated for the total value of an investment you don't even own if you are willing to pay the premium for the "insurance" that will pay you for the lost value that will occur if the bonds (or whatever) go south. You can bet the bonds will fail and get paid their value at the time of the contract even if you never owned the bonds.

It's legal.

All the financial institutions in the world were involved in insuring and counter-insuring assorted iterations of each other's holdings and the speculative values of assorted debt instruments they might or might not even own. For fun and profit. And such transactions are not regulated.

Great system, eh?

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