Bad Economy for Dummies: Lesson 1

Are you curious about all the doom-and-gloom surrounding the economy, but can't make heads or tails out of what economists are saying? well, I've been attempting to decipher it all and I decided to post what I'm learning here.

I know some of the kids are interested in this... hopefully, it won't be tooooooo boring....

Lesson one: Credit Default Swap
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You don't have to listen to financial news for long before you hear the term "Credit Default Swap", or CDS. It sounds like some esoteric complex blah-blah that only a finance geek would understand, but really, it isn't that hard to get. And once you do get it, you'll see why our economy is in such a terrible mess.

Basically, a CDS is kind of like a bet. The CDS buyer bets the CDS Seller that some third party entity will fail to meet its financial obligations. As long as that third party is doing okay, the buyer pays the seller a regular premium, like an insurance premium. But if that third party should default or begin to miss payments, then the seller has to pay off the buyer --- the buyer has "won the bet" (click to enlarge):

You can imagine, sometimes a lender would want to do this. If a lender lends a huge sum to a risky company, they might want to buy a CDS so they will get paid something if the risky company goes bankrupt.

However, neither the buyer nor the seller has to have any financial interest whatsoever in the third party they're "betting" on. The buyer might be a lender to that third party, in which case he's trying to protect himself, but that doesn't have to be the case. He can just be a spectator on the sidelines.

Chimney Springs Analogy

Here's an analogy to make things clearer.

It's kind of like if Mike bet Sid that the Esodas next door would default on their mortgage this year. Every month that the Esodas make their payment on time, Mike would give Sid $150. But if they miss a payment, Sid would have to pay off Mike, say, $5000.

Mind you, the Esodas have nothing to say about this. And if their credit is good, Mike might have to pay less per month, while if their credit is bad, the monthly payment would be a lot higher.

Now imagine that the Esodas get into trouble and are late with a payment. Sid starts to worry. Now, he thinks he might have to borrow that $5000 to pay off Mike. The bank that would lend Sid the money looks into purchasing a CDS to offset their risk, but they find that the price of Sid's CDS is going up, because of the bad deal with Mike. Now the bank WON'T lend Sid the money, because it's too costly to offset their risk.

Further, imagine that Sid was counting on that $150 every month from Mike to make his car payment. If the Esodas do default and Mike stops paying, Sid won't have the money to pay off his car loan, and he will default on any CDS purchased by someone else (the Esodas?) against his car loan debt... and the seller of Sid's CDS might face the same problem... in a kind of domino effect...

How is the CDS market contributing to the current downturn in the economy? Well, let's look at a real world example.

When giant Bear Stearns looked like it was getting into trouble, the CDS market went crazy as speculation grew --- anyone & everyone was trying to "bet" that Bear Stearns would default, driving the price of a Bears Stearn CDS higher and higher. This made Bear Stearns look even more vulnerable and risky, until finally the company could not get the credit to which it would normally have access. So then, they actually couldn't make payments that they would have made in more normal circumstances. Bear Stearns then had to be "rescued" (purchased by JP Morgan, the company that incidentally invented the CDS ) to avoid triggering all of the huge payouts on all of the CDSs taken out.

Problem is, there was an awful lot of this going on, and pretty much no regulation whatsoever. Because ANYONE could purchase a CDS, regardless of whether or not they lent any money to the company, speculation could run wild.

It's as if the Esodas, whose mortgage might only be $150,000, had $10 million dollars of other people's money at stake if they didn't make their house payments. Sounds crazy... but...

...this is what is happening right now to AIG, the biggest of them all. AIG sold a huge amount of CDSs. (see "AIG appears to have sold [CDSs] in large quantities to practically every financial institution of significance on the planet. " ) When times were good, AIG was collecting lots of money in premiums from these CDSs, it was easy cash. But now, as defaults are growing, they are in serious trouble as they have to pay out many times what some of the debt was worth, at a time when the premiums coming in from CDSs are dwindling.

How is all this legal, you might ask? That's something I'll look into in a future lesson.

For more info, check out the Wikipedia entry where I got this info.

Next time, Lesson Two: why some people think "mark to market" accounting is making a bad thing worse.