Island Investing: Credit Default Swaps

Island Investing
Cale Smith, MBA
August 1, 2009
KeysWeekly.com

Q. What are credit default swaps?

A. A credit default swap, or CDS, is a contract that promises to cover losses on certain securities, including corporate debt, municipal bonds, and those securitized mortgages I mentioned last week, if they default.

Buyers of credit default swaps make monthly payments to sellers, who agree to make a large payout if the underlying instrument goes into default. In the vernacular of Wall Street, a CDS allows an institution to unload its risk exposure to a third party. While designed to insure against defaults on debt, these swaps are not considered insurance in the traditional sense by regulators.

Here’s why investors should know more about these swaps:

(1) The current value of the global credit default swap is estimated to be $55 trillion – greater than the GDP of all the countries in the world combined;

(2) These multi-million dollar contracts are often executed in minutes between Wall Street traders using nothing more than instant messaging programs;

(3) These swaps require little to no cash upfront to enter into; and

(4) There is no regulatory agency in charge of credit default swaps, no centralized clearinghouse that administers them nor anything publicly disclosed about them.

I should also mention that in 2000, Wall Street successfully convinced Congress to pass legislation that banned the regulation of credit default swaps. In addition, you may recall that insurance giant AIG imploded a few months back, threatening to bring our entire financial system to its knees. The reason? Credit default swaps.

Perhaps you’ve seen this movie before. These derivatives represent another huge risk to the global financial system, yet few people are talking about them.

Credit default swaps were supposed to work similar to car insurance except, well, they don’t. The analogy would go like this:

Bill thinks his neighbor Larry is a bad driver. Bill goes to an insurance company and gets
collision insurance on Larry’s car because he thinks Larry will crash it. If he does, Bill will collect on the insurance he purchased.

Note that Bill does not own Larry’s car. He has zero ownership interest in any part of it. By buying insurance on it, however, he can nonetheless profit from Larry’s mishap.

Not only that, but even though Larry’s car is only worth $10,000, Bill can take out an insurance policy on the car for $10 million. So can Susie across the street. And to top it off, Larry has no say over whether or not any of his neighbors take out insurance policies on his car, nor will he be notified if they do.

This is a huge problem. Why? Because, to continue the analogy above, it rewards Bill for cutting Larry’s brake lines. By causing the car to crash, Bill will collect a lot of money.

In short, credit default swaps encourage speculation and market manipulation on a multi-trillion dollar scale. As one author put it, they’re like buying insurance on the Titanic from someone on the Titanic. It’s time they disappear.

Cale Smith is the portfolio manager for the Tarpon Folio and Gecko Folio. His firm’s website is www.islainvest.com and his blog is www.caleinthekeys.com.

Cale Smith

About Cale Smith

Portfolio Manager at Islamorada Investment Management.
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2 Responses to Island Investing: Credit Default Swaps

  1. Kirk Kinder says:

    I am not convinced they need to disappear…they need total transparency. Once that happens, I think folks will start to use them as true risk mitigation techniques as opposed to speculative bets.

    And, these babies have yet to really collapse. With more outstanding CDS than Global GDP, it won’t take a big default ot cause a major crisis.

    • Cale Cale says:

      A total ban might be draconian, but I’m not convinced the genie will ever go back in that bottle…nor will the regulators ever be able to keep up.