Home > Simple Explainations > Background 1 – Credit Default Swaps

Background 1 – Credit Default Swaps

I’ve been wanting to make a post about the mechanics of how the world got itself into this giant financial crisis, but looking closer at what was involved leads me to believe that I might as well write it in Greek. Because most people wouldn’t have any idea what I was talking about.

Typically one would provide links to simple explanations, but none seem to exist. So I am going to make a few short posts to try and cover a few concepts. This one is “Credit Default Swaps.”

This is an important thing to understand, at least on a basic level, what the hell a credit default swap is and where they come into play in the grand scheme of things.

Essentially a CDS is insurance. There are technical differences that really make it different, but for all intents and purposes a CDS is insurance, and it works like this:

Your neighbor wants to borrow 100,000$ from you to add on to his house. You happen to have 100,000$ laying around so you agree. Your neighbor agrees to pay you 1,000$ a month (to keep everything simple) for 12 months and pay the principle back after that.

You make a cool 12,000 on the transaction. Your concerned he might default on your loan however, so you look around and talk to the Jones’s across the street. You ask them if they want to make a little money on the side and of course they would. You offer to pay them 50$ a month if they agree to pay your neighbors debt obligation if he can’t.They agree to it and essentially, you have your 100,000$ back, plus a 11,400$ profit.

That is a credit default swap. In the simplest terms possible. Now the problem happens to be that in the real world, these massive banks and investment firms, like AIG, don’t have to keep any capital in reserve on these CDS’s, at least in addition to what is required as a banking institution. With AIG for example, they had no way to pay the debt it would owe, in the event a massive amount of debts it had underwritten were defaulted on. The tentacles reached so far through the financial system that in order to keep the whole thing imploding, the us government decided it had to bail out AIG, to the tune of around 173,000,000,000.

Lets remember that AIG could have been purchased for around 2 billion.

The power of the CDS is pretty shocking. The idea is to make lending risk free. And it does on paper, because in my example above you had sold off the risk. You were getting your 100,000$ back no matter what, the only loss would have been the interest not paid and the 50$ fee paid to the Jones’s every month. What happened with AIG was the Jones couldn’t pay.

It gets more complex in the way that, if we were not talking on the personal finance level, a company could lend that same 100,000 dollars to 10 different people, and have ‘the jones’s” take over the debt in a default situation. I’ll get more into that when I actually get to a post about the financial crisis.

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Categories: Simple Explainations
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