Credit Default Swaps For Dummies

“If it doesn’t pass, then heaven help us all.”

Allow me to teach you what a credit default swap is and why it’s so important to what is happening to the economy today.

Virgle Kent borrows $50 from me. I want to get insurance on his debt in case he goes broke. I go to Roissy and say, “Hey, Virgle Kent owes me $50. Can you insure that debt?”

“I’ll insure it if you pay me $4 a year,” Roissy says.

“Done!”

Roissy is betting that VK will pay me back, especially since he did his homework by looking at VK’s credit rating and saw it was superb. Roissy wrote me a credit default swap, an unregulated derivative invented in 1995 by JP Morgan.

Unfortunately Roissy has some problems with his business, and he no longer even has $50 to pay me in case VK goes broke. The premiums I gave him are long gone. Credit agencies notice this and tell Roissy to find some cash or his credit rating goes down. Roissy is fucked because if his credit rating goes down then he won’t be able to raise cash at good rates to keep his business open (today’s large businesses need a constant flow of credit to maintain operations). Sure enough his rating gets killed and Roissy goes bankrupt.

Now I’m in trouble. The debt I had on my books that was insured is now uninsured. The agencies look at my books and see I have this exposed debt and they downgrade my ass. I have no choice but to enter bankruptcy as well. But I happened to be knee deep in the CDS game too. I wrote a ton of them for Arjewtino, insuring the debt owed to him by other parties. When I go down it puts pressure on him. Like dominoes we fall.

In the carnage it turned out that the ratings we used to judge each other’s debt worthiness was bogus from the start. Essentially we all gambled like we would at a blackjack table, but we did it while drunk. And blind.

The insurance company AIG wrote $78 billion worth of swaps.

Ivy League MBA’s turned the CDS into an even more insidious device. In ways that I will not begin to understand, swaps were used not just to insure against debt but to speculate if companies would fail or not. It turned out that while VK only owed me $50, there were swaps written worth $500 between parties that VK didn’t even know about! The swaps became a means to make money instead of a simple insurance policy. This was enabled by a government run by politicians whose treasure chests were stocked full of kind donations from the big bankers. They did not hesitate to look the other way.

A lot of swaps were written by banks and businesses that are now very sick from making bad bets and possibly outright fraud in the housing boom. (Who would have thought that giving no money down / no-doc loans was a bad idea?)

Here’s the bad news:

…there are $45 trillion of credit default swaps out there. A default on a mere 10% would cause an economic disaster. Unfortunately, it’s guaranteed to happen.

Actually that was the good news. Here’s the real bad news:

The Bank for International Settlements recently reported that total derivatives trades exceeded one quadrillion dollars – that’s 1,000 trillion dollars. How is that figure even possible? The gross domestic product of all the countries in the world is only about 60 trillion dollars. The answer is that gamblers can bet as much as they want.

The quote up top was said by Henry Paulson.

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  • Dave

    That may have been the best explanation of a CDS that I’ve seen yet. I came looking to have more sex, and instead I get an explanation of complicated financial instruments? What a deal?

  • Ninja Zombie

    Ok, good post, up until you reached the actual bad news. $1,000 trillion in derivatives? Most likely nothing to worry about, since most of those trillions are different sides of hedges. A simple example:

    I’m holding $100. I sell you a $100 Obama future (i.e., you get $100 if Obama becomes president). I sell Roissy a $100 McCain future. I also sell some chicks a $100 Hillary future, some computer geeks a $100 Ron Paul future, and some rednecks a $100 Palin future.

    Holy crap, I gambled $500 but I’m only holding $100!

  • BasilRansom

    Roosh,
    I was talking to a business professor the other day about the whole debacle, and he explained it differently.

    You said: “Unfortunately Roissy has some problems with his business, and he no longer even has $50 to pay me in case VK goes broke. ”

    As he told it, it was the credit ratings of the loans themselves that were downgraded – the default rate was higher than initially expected, so credit rating agencies downgraded them. And, because AIG had underestimated the risk, the premiums they were charging were too low, so they didn’t have enough money to properly insure the loans.

    So the fault lies with VK’s credit rating, not Roissy’s business acumen.

  • Anonymous

    and how is this going to help me bang sluts?

  • to Ninja Zombie

    Hey I posted this article looking for more explanations on Roissy’s website, it goes in line with Roosh’s post with the end mentioning derivatives. Ninja Zombie can you expand on your opinion on derivatives, in layman terms if possible. The following author, like Roosh’s link, sees it as a dangerous timebomb.

    Thank You for any help.

    ========================================

    The world of finance which Roubini calls as transaction-oriented system looks a bizarre, dollar jungle now. A peep into this mind-boggling labyrinth will unnerve even the most diehard among optimists. The world of finance today is controlled by derivatives. What is a derivative? ’Derivatives are financial Weapons of Mass Destruction [WMD]’, ‘now latent’ but ‘are potentially lethal’. This is not socialist Fidel Castro, but, capitalist Warren Buffet speaking recently (on March 10, 2008). Yet, the most among those who count in the world seem unaware of this WMD. ‘Politicians, senior executives, regulators, even portfolio managers have limited knowledge’ about it, says an expert Web on derivatives. Derivative is a financial instrument whose value is not its own, but derived from something else, on some underlying asset or transaction, such as commodities, equities (stocks) bonds, interest rates, exchange rates, stock market indexes, why, even inflation indexes, index of weather!

    The CDOs (collateralised debt obligations), by which the underlying US local subprime loans were palmed off to other continents, was, till the fraud was not out, a reputable credit derivative. So derivative is not only a WMD but also an ICBM, an Inter Continental Ballistic Missile, that hits across continents!

    Also, the virtual derivative economy is gradually decoupling itself from the actual in quality as well as size. Hundreds of exotic derivative products have been innovated and innovations by the best minds are continuing.
    Mind-boggling size

    The population of these beastly financial products has grown to gigantic levels that is beyond the competence of any system, mind, or force to deal with. The sheer collective size of these modern financial beasts is terrifying. According to the Bank of International Settlements [BIS], the aggregate derivative positions of banks grew from $100 trillion in 2002 to — believe it — $516 trillions in 2007, that is over 500 per cent in five years!

    Yet they do not appear in bank or corporate balance sheets. Some of the vital actuals seem pygmies in comparison to these virtuals. The total derivatives are more than ten times the global GDP [$50 trillion]; some seven times the world’s estimated real estate value [$75 trillions]; more than five times the world’s stock values [$100 trillions]; more than 33 times the US GDP [$15 trillions] or the US money supply [$15 trillion]; 172 times the US federal budget [$3 trillion] — it can go on. The size of the virtual economy is indeed petrifying. Worse, it unpredictably targets, yet accurately eliminates, the distant and the unwary as the CDOs did.

    A decade earlier, Long Term Capital Management [LTCM] a hedge fund co-promoted by two Nobel laureates, collapsed. Its loss of $5 billion was peanuts compared to the trillion dollar-plus loss that is forecast now. Yet the LTCM fall nearly snuffed out the global monetary system. The derivative economy was much smaller then. When billions could devastate the world market then, what could trillions not do now? It is so huge now that, no one, not even all governments and central banks in the world put together, can control this huge and growing population of derivatives. This is what Akio Morita, the former Sony Corporation chairman, told the Group-7 leaders as far back as 1993, when the size of the derivative population was far less. With the derivatives growing so malignant, it is not the actual finance which controls its derivative, but, the other way round – the virtual controls the actual. What, if this off-balance-sheet virtual architecture collapses?

    It is so fragile that it can. Martin Wolf warns “the connection between housing bubble and the fragility of the financial system has created huge dangers, for the US and for the rest of the world.” If a collapse starts, it is beyond any known power’s power to stop or repair it. The balance sheet of the whole world is too small for it and the actual will too meet the fate of the virtual.

    Roubini’s caveat regarding transaction-oriented financial system being in crisis and Warren Buffet’s warning about derivatives as financial WMDs, expose how fragile is today’s virtual financial architecture, which is several times the actual.

  • Roosh

    “As he told it, it was the credit ratings of the loans themselves that were downgraded – the default rate was higher than initially expected, so credit rating agencies downgraded them.”

    Yes I have heard this as well. I think there are multiple ways the swap could go bad. Take home is that they are currently going bad because of piss poor decision making somewhere in the chain.

  • NC

    It actually gets more screwed up, as some companies (*cough* GM) have many times more money betting against them (that they will default) than they do capital in the company. Which means that that counterparties to those swaps find it more profitable to keep the company alive than to pay out on the swap. There are more than a few of these zombie companies out there, kept alive purely by unintended consequences of the CDS market. Oh and don’t call it insurance! Phil Gramm made sure it’s not considered insurance otherwise you’d need a capital reserve and need to be regulated.

  • http://www.vksempireofdirt.com Virgle Kent

    So what you’re saying is that the fundamentals of our economy aren’t strong????

    oh fuck…… so do I still have to pay the 50 or what?

  • Ninja Zombie

    Anonymous commenter: “Ninja Zombie can you expand on your opinion on derivatives, in layman terms if possible.”

    I don’t have much of an “opinion” on derivatives. They can increase or decrease leverage, and apparently counterparty risk is something we really don’t understand.

    My only point is that $1 quadrillion in derivatives trades is not remotely the same as a bet with a possibility of losing $1 quadrillion.

  • http://www.therawness.com T. AKA Ricky Raw

    So basically, this mess we’re in all started because VK is a moneygrubber?

    T. AKA Ricky Raw’s last blog post: Get ‘Em Bruce.

  • z

    that post is a terrific summation of some of what has went down on Wall Street…….

    This is bigger than the dotcom bubble in 2000 Im afraid. They just didn’t learn their lesson up there on Wall Street last time out. Warren Buffett (and John David Rockefeller) got so rich by steady decent profits over TIME, not in huge quick gains. Too many now look for huge quick gains and try to pass the ball too deep down the field way too often. AIG was apparently betting that nothing was going to fail under their underwriting. All those lousy mortgages they insured are spread out in so many funds that everybody is holding some of them. AIG was apparently holding too many.

    What I dont understand was that the FED is going to loan AIG much more money that what AIG is apparently worth—-I wish we could all get such a deal.

  • BasilRansom

    “Yes I have heard this as well. I think there are multiple ways the swap could go bad. Take home is that they are currently going bad because of piss poor decision making somewhere in the chain.”

    Yeah. My other finance professor was saying that they were trading such complex securities that next to no one understood them, not even the ratings agencies.

  • Ninja Zombie

    Z: “AIG was apparently betting that nothing was going to fail under their underwriting.”

    Actually not quite. AIG is organized in the following way. There is the company, AIG, which is basically an investment bank. AIG owns various subsidiaries which insure different things. Each subsidiary is (by law) solvent, and fully capable of meeting their obligations.

    The investment bank part of AIG got screwed, however. So what should happen is it dies, the subsidiaries are spun off, meet their obligations, and AIG shareholders/executives/employees get hurt.

    Only one problem: the Governor of NY allowed AIG’s investment banking arm to “borrow” from the subsidiaries (presumably to protect jobs in NY). Basically, he made a small problem into a big one, in the hopes that the fed will save AIG, the banking sector, and NYC.

  • Roosh

    “Basically, he made a small problem into a big one”

    Fulfilling the role of government. Hence why any government intervention in this will make things worse.

  • Todd Hackett

    this is good, but i hope you’re gonna follow it up with,
    “date-swapping for dummies, in Rio” or something, like the old days

  • Tampa

    While the CDS market is the main problem in all of this, it is really the leverage rate at which we allow institutions to operate at.

    If the rating agencies can’t do their job, the federal government needs to step in and say a 10-1 leverage positon is way to much.

    You can only leverage at 5-1.

    This whole CDS market is a bunch of bullshit if you don’t go out and borrow a slew fuck of money. If you are a solid, balance sheet solvent company, you don’t have a f-ing thing ot worry about. But when you go out and borrow leverage at 25-1 position and then the people you lend to are at a 25-1 one position, it just becomes a big shit fuck.

    Its debt that his ruining this country. This theory of “managable debt.” Its fucking non-sense. If companies didn’t borrown out the f-ing ass, they wouldn’t be in this situation.

  • DF

    I respect what you’re trying to do here Roosh but you highlight the knowledge gap between laymen and finance professionals. A loan is an asset in a bank’s books because it performs – you get interest payments – not a liability as you framed it. Subsequently, a loan to a well rated VK wouldn’t subject you to a downgrade simply because its a clean credit (without mitigation). You might allocate more economic capital against it but it won’t threaten your rating. In addition, if he’s well rated there would be less reason for you to go out in the market and purchase protection. Now if we assume VK is an FI (Financial Institution) things change because his ability to perform may be in jeopardy because of off balance sheet items that he must service.

    There is still much to be concerned about. What’s disturbing to me is that when you look at many joint default models, the probability that an obligor as well as the credit protection provider will default on the obligation is less than any one default but is this really true? Not necessarily. The PD (probability of default) is typically less for an FI, from whom you purchase a swap, UNDER NORMAL CONDITIONS. PDs usually have a 1 year time horizon. As you rightly stated the FI is dependent upon its rating for many of its activities and making sure certain things remain off balance sheet is key. If an FI suddenly is saddled with lots of off balance sheet committments then it looks over leveraged and that’s when the trouble starts.

  • Roosh

    “you highlight the knowledge gap between laymen and finance professionals”

    You mean the finance MBA’s with “market discipline” who are begging for 700 billion?

  • http://insomniaccoder.com Pedro Vera

    Excellent read.

    Pedro Vera’s last blog post: Credit Default Swaps For Dummies.

  • DF

    You mean the finance MBA’s with “market discipline” who are begging for 700 billion?

    You know what, you’re adding to my point. If you blame finance MBAs for this mess then be weary that they had advanced knowledge and still got us into this predicament. You don’t know the difference between an asset and a liability and yet you presume to be knowledgeable enough to teach others. What you should know is that most derivatives were, and continue to be, developed by PhDs. Its the MBAs selling what they don’t truly understand and that is dangerous. Like I said, I respect what you were trying to do here but this is not an easy subject.

  • Triumph

    I hedged against furball not masturbating on your pillow and lost my doghouse

  • Anonymous

    Still confused. Gamblers can bet as much as they want, but when they lose, someone else gets that money. So if there is 1,000 trillion in derivatives out there, and let’s say someone could write a check for that much, then who ends up holding all that money? Who’s sitting there hoping this all defaults because they’ll then be owed billions to a trillion dollars, as I’ve never heard of anyone gaining out of all of this.
    (I’m sure a lot of it is a wash, where the same person who owes a billion is also owed a billion, but it can’t all be that way?)

  • http://Arjewtino.com Arjewtino

    So when am I getting my money?

    Arjewtino’s last blog post: Douchebag: How an otherwise perfect word became overexposed.

  • Blow harder

    “Who’s sitting there hoping this all defaults because they’ll then be owed billions to a trillion dollars, as I’ve never heard of anyone gaining out of all of this.”

    That is indeed the really interesting question.

    If the CDS market is threatening to destroy the world economy governments could and should just make the things illegal and unenforceable retroactively.

  • lelandj

    A Credit Default Swap, (eg CDS), is a kind of derivative where a lender, who issues notes, bonds, mortgages, etc, swaps the risk the borrower will default on the loan to a third party, like a bank or insurance company, for a sum of money. For example, if First Mortgage finances home owners, it might ask Big Bank to assume the risk that the home owner will default on the loan for a sum of money. Thus the risk that the home owner will default on the mortgage is swapped to Big Bank, and First Mortgage pay a sum of money for the default protection.

    Another swap occurs if the mortgage borrower default on the loan. Big Bank will pay First Mortgage the spread between the face value of the mortgage and the real value of the mortgage in default, and First Mortgage will swap, (eg sign over) the toxic mortgage to Big Bank.

    The original intent of the CDS was to create an instrument that would facilitate the financing of housing by having a third parties assume the risk of loan defaults, like a default on a mortgages, but what seems to have really happened is mortgage companies and other mortgage lenders started writing risky loans; because, they had their backs covered by third parties who had assumed the risk of mortgage defaults.

    The housing market went through a wonderful boom, but eventually a bubble began to appear. Everyone in the housing market wanted the boom to go on forever, including builders, real estate agents, mortgage companies and banks; because, everyone was making tons of money. Towards the end of the housing bubble, mortgages were created with interest rates even below sub-prime, which is the rate banks charge each other for funds. Initial low interest rates were necessary in the mortgages to get payments down to a point where the borrower would qualify for the loan. The Federal Reserve Chairman assured congress and the American people that the housing bobble was contained, even as the building industry continued to crank out houses. The sub-prime mortgage were variable rate with an interest rate time bomb that adjusted the interest rate back to normal. When the interest rate time bomb went off, the borrower’s monthly mortgage payment doubled or tripled driving many into default on their mortgages.

    The Housing bobble eventually burst, and borrowers began defaulting on mortgages in droves, which depressed housing values causing even more defaults in a kind of domino effect, and the housing industry had way over built even before the bubble burst. I’m sure the CDS problem was aggravated by others who really didn’t have any mortgage loan risk to swap to third parties, but only wanted to gamble on a housing market bust, but to what extent these kind of mortgage CDS(s) were leveraged, I’m not sure.

    Regards,

    LelandJ

    Regards,

    LelandJ

  • Rico

    V.K. borrows 50 from Roosh at say $5.00s per year. Roosh pays Roisssy $4.00 per year ins. premium to avoid any risk. So Roosh now makes $1.00 a year worry free. Roissy makes $4.00s a year in taking on Roosh’s and V.K.s risk. And as long as V.K. keeps paying the $5.00s in interest everbody is happy. As I see the situation Roissy financial condition at this time is irrevelant to the transaction as long as V.K.keeps paying the interest. If or when V.K. will or could default should be the determining factor in the transaction at this moment in time. When VK does fail then Roissy’s financial condition becomes revelent for Roosh who is no longer worry and risk free and this is why these swaps are nutty.
    Roosh lent his money out to VK. To be risk free he gave more his money to Roissy. V.K. got all the principal and Roissy got 80% of the interest putting Roosh in the position of the only one at risk in this transaction since neither VK or Roissy ever put their money into play. If VK and Roissy were con men they could have used $5.00 bits of Roosh’s $50 and used it as interest payments of which Roissy took $4.00 dollars. After 3 months VK and Roissy claim bankruptcy and hide what they haven’t spent of Roosh’s $50. bucks. Ambac and the other insurers were never at risk and made billions as long as the primary kept paying those premiums.

  • lelandj

    Below is a link about derivatives and risk exposure to some of the major bank in the USA form this type of investment. Many of the bank with large risk exposure due to derivatives, including CDS, have required government bailouts.

    http://www.gold-eagle.com/editorials_00/ci091500.html

    Regards,

    LelandJ

  • Iamawilson

    Please – Our planet is facing a dire future. WE need to work together. We need a transparent irrefutable environment. I went to Bank of international settlements site and found smaller numbers. Please draw a path to the numbers in dollars you quote: 1,000 trillion credit default swaps, 516 trillion aggregate derivative positions .

  • lelandj

    A special kind of derivative, (eg Mortgage Backed Securities or MBS), played a bigger role in the current international credit crises than did Credit Default Swaps.

    A MBS is an instrument peddled to investors by mortgage companies, and other companies, that held mortgages. The MBS paid an attractive rate of return, were backed by assets, (eg a pool of mortgages), and the yields of the MBS were serviced from the payment of interest and principle from the mortgage borrowers, (eg the hone owners). MBS were brought, sold and traded in various markets, and their values depended on the underlying value of the pool of mortgages.

    The MBS were popular investments internationally; because, MBS provided a relatively high rate of return, and were suppose to be safe, LOL; since, they were backed by mortgage assets.

    Below are a couple of links for more information:

    http://en.wikipedia.org/wiki/United_States_housing_bubble

    http://en.wikipedia.org/wiki/Mortgage-backed_security

    Regards,

    LelandJ

  • http://otieann-merkavamk.blogspot.com/ panzerchic

    Thank you, thank you, thank you for clarifying “credit default swaps.” I have a serious case of stupid when it comes to finances. But that’s because I don’t have any money. I thought your explanation was so good I noted your blog site in my blog. I didn’t realize I should have given it a rating ie. G PG R X. No one reads my blogs anyway so I guess it doesn’t matter. Looks like some of your thinking only went as deep as your penis. But that’s good. It’s not meant to an insult.

    I’m a cat lover and have had dozens of pet cats, but never once did I see any of the toms masturbate. One peed in my hair once. I just thought he was marking me as his territory. Well, you learn something everyday.

    panzerchic’s last blog post: A Great Big Mess.

  • http://otieann-merkavamk.blogspot.com/ panzerchic

    Oh good Lord, that penis remark was so stupid. I didn’t mean it. You see I am old and have been there, done that. I just can’t get used to the idea of sex, sex, sex, and me not a part of it. The remark just blurted out. I apologize. Have all the fun you can while you can. Just don’t forget about the many VD’s that are out there.

    panzerchic’s last blog post: A Great Big Mess.

  • I”M LOST!!!

    I AM CONFUSED ABOUT ONE THING.

    Ok! If the ORIGINAL investor loans $50 to VIRGLE KENT, this means the ORIGINAL investor is down negative 50. Next, the ORIGINAL investor now insures his 50 by paying ROOSHE 4$ per year. How does the ORIGINAL investor earn profit if he or she is still DOWN NEGATIVE 50 DOLLARS?

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  • lucabrazi

    The end is near,

    we live in a virtual economic and monetary system that is designed to bring cahos,the elite Illuminate are behind the whole thing pulling the strings and manipulating the rest of us as they please. Beware!! they are Luciferians with only one aim, to prepare the field for the arrival of the dejal (antichrist). fellow humans of all race and religin brace yourselves and be prepared for the final battle.Allah help us all.

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  • tom

    So at the end of my swap loan 7 years all I owe is the oustanding balance

  • http://WEALTHWISEADVISORS.COM JB

    It is incredable to think that what amounts to an insurance product can exist with out any capital backing up the CDS. There was a reason that these products were out lawed in the USA.

  • Normal person

    WHO IS alah? You mean ALAN? I don’t think alan will help us at all.