“A credit default swap (CDS) is a credit derivative contract between two counterparties, whereby the “buyer” or “fixed rate payer” pays periodic payments to the “seller” or “floating rate payer” in exchange for the right to a payoff if there is a default or “credit event” in respect of a third party or “reference entity”.”
…Riiiight, that clears up a lot??? The monumental complexity of the current financial system has thrust itself upon the country, delivering blow after blow as banks plummet into failure. So what are we to take from this, those of us who have no idea what the derivative market is, and don’t have millions invested?
So, simply put, a CDS is an insurance on (bad) investments – they pay in the event of a default on a debt or loan (credit event). This CDS market is not visible to the public, has no “real value”, and is largely untracked. The estimated value of all outstandnig CDS’s is to the tune of $60 trillion. Perhaps most important; they are not guaranteed. That means that every party trading CDS’s is essentially married to every other in an uncomprehensibly complicated web of trades.
American Investment Group’s (AIG) CDS portfolio is estimated at $400 billion – estimated because there is no clear market value. Also unclear is who exactly is tied to this portfolio; corporations, banks, hedge funds, even sovereign wealth funds, and many more. That is what they mean when they say, “shockwaves throughout the financial system”. When one of these players defaults big time, everyone is at risk.
What caused the meltdown? AIG basically has a credit rating. When their credit rating falls, they have to put up more money – kind of like a down payment on a loan. When AIG started going bad on some of its CDS’s, undoubtedly due to the “shockwaves” from the likes of Lehman Brothers, there credit rating dropped. This is where the $85 billion dollar credit line came from. AIG had to come up with around $80 billion to avoid going under – so, despite claimes to the contrary, the Fed provided the funds in an attempt to contain the meltdown.
Finally, what does this mean for you and me? Why does this matter at all? Shouldn’t these greedy companies be allowed to fail? Unfortunately, due to grossly unregulated financial markets, that would drag the rest of the system, indeed the whole country or world, into serious depression. Make no mistake, this is the worst state of the global economy since the 1930′s. In the near term, it means that lenders are less inclined to loan money, as the current climate necessarily means greater risk. Small business loans, car loans, school loans, everything.
Consider this; you got a loan for, say, $25 grand two months ago to rent shop space and renovate it to start a bakery. You’ve done all the decorating and preparing, now you need a business loan to buy all of the equipment and to start paying employees. No, you don’t have $15 grand to put down, no you don’t have great credit, or much credit at all – but 2 months ago the bank assured you it would be no problem. Now, given the economic climate, your loan just seems way to risky. So you are stuck with an empty shop space and $25 grand in debt. Now you default on that original loan, furthering the crisis.
So what is next? The government will be executing a massive, massive buyout to rescue the economy. I hate to say it, but it is a good thing. Well, it is the only thing really. The question remaining is whether or not they are going to do it well. $300 rebate checks just ain’t gonna cut it. Treasury, Fed, and politicians are working feverishly to find a solution – not very reassuring. My biggest hope is that this stimulus will reach the hands of the innocent. While it is imperative that banks stay afloat, the likes of AIG CEO Robert Willumstad – expected to receive a smooth $7 million payout for his 3 months at AIG, during which the company’s worth fell 97% – clearly deserve no tax dollars. My fear is that the massive buyout will be along the lines of the various and sundry (failed) attempts to save the economy, this time at a risk far to high to fail.