Friday, September 26, 2008

What is a Credit Default Swap?

Claire's father is an executive at Deloitte, and generally knows a lot more about economics than I do. Last night, we sat around the dinner table and he explained the current financial crisis to me, or at least attempted to. I'm sure that Claire was not thrilled about me keeping everyone up late to talk about failing investment banks and credit default swaps. He actually had a good way of explaining the latter though.

First, understand that they are already a big problem. From the Washington Post:
"Scarier than the bad mortgages are those unregulated credit default swaps that financier George Soros has been warning about. There are $45 trillion of those esoteric instruments sloshing around the global financial system. They were invented as a hedge against debt defaults, but even the financial smart guys don't fully understand their impact or how to price their real value."

So what are they?- I asked Claire's father. Here's how he explained it to me:

Imagine that Christine (my mother-in-law) borrows 100 dollars from Rufus. In exchange, she gives Rufus a bond pledging to pay back the 100 bucks.

But, Rufus starts worrying about it. Maybe Christine isn't so good with her money. How can he be sure?

So, Claire offers to insure the bond for 20 "basis points", or about 20 cents.

Rufus is still worried, so Claire offers to give Rufus 100 dollars and take the bond. So, now, she could well have $100.20 in the end, which is a decent profit (imagining that she has several of these bonds with the same basis points). Besides, Christine has never defaulted.

But rumors start circulating about Christine. Maybe she really can't pay back the loan. In the end, she has losses of 2%, so Claire is out $2.00 of her own money.

AIG wrote a lot of these policies apparently.

Another thing her father said that was interesting was to relate a comment that had been made to him about two years ago by a friend in the financial sector: "There is entirely too much liquidity sloshing around the world economy right now, and things are all out of balance. But we can be sure that the market will eventually right itself, and when it does a number of big names are going to disappear." That is coming to pass.

Lastly, he said something worth pondering- in most of our lifetimes on earth, there has not been a financial crisis in the western world equivalent to this.


Brian Dunbar said...

AIG wrote a lot of these policies apparently.

Haw. The last company I worked for had a similar moment in 2002.

The telecom market when 'phhht' and we suddenly realized that having 75% of your customers in one market was, perhaps, not such a good idea.

Well, actually, we knew it was a bad idea before that but it was sure easy to build on existing relationships than try and get new customers in new fields ...

Rufus said...

I think part of what's happened in the lending industry is easy to see with credit cards. When I was 16, it was still pretty difficult for me to get a credit card, and I never ended up getting one. Now, they sign our students up for them at the university bookstore and outside of sporting events. Basically, all that needs to happen for the banks is for their lenders to start realizing how crazy things have gotten, and then they're in trouble.