Maybe I should change the name of the this blog to Living Reflections of Doom and Gloom...
Since seeing Mort Zuckerman yesterday, I've been thinking about his credit default swap comment. I knew what a credit default swap was, but I hadn't really thought about. Well I've thought about it and then my eyes got big and then I went online.
First, if you don't know, read what aCredit Default Swap is.
What does this mean? In laymen's terms (Washington Post):
Because these contracts trade on unregulated derivatives markets, no one knows who holds the losing side. But it's a good guess that if defaults rise to historically normal levels, highly leveraged hedge funds will take a big hit.The credit-default swap has become so central to global finance that its size is estimated at $43-trillion. If the losing side is unable to make good on even a fraction of a percent of those contracts, it could set in motion a chain reaction that could easily rival the subprime debacle.
Yeah, that's 43 Trillion. For comparison purposes, US GDP in 2006 was 13 Trillion.
Let's move on to the Wall Street Journal:
Bill Gross, chief investment officer at Allianz SE's Pacific Investment Management Co, or Pimco, recently told investors that if defaults in investment-grade and junk corporate bonds this year approach historical norms of 1.25% (versus a mere 0.5% in 2007), sellers of default insurance on such bonds could face losses of $250 billion on the contracts. That, he said, would equal the losses some expect in the subprime-mortgage arena.
And even more:
This isn't like life insurance or homeowners' insurance, which states regulate closely. It consists of financial contracts called credit-default swaps, in which one party, for a price, assumes the risk that a bond or loan will go bad. This market is vast: about $45 trillion, a number comparable to all of the deposits in banks around the world...This market poses challenges for would-be regulators. It isn't clear, for instance, how securities laws on fraud and insider trading would apply to credit-default swaps, because it's not clear in what way they are even securities; they are private contracts...
The market for swaps has grown fivefold just since 2004. It has no publicly posted prices; the contracts are sold privately among dealers. The market began 12 years ago with insurance against defaults on corporate bonds, expanding in 2005 to mortgage securities...
And I really enjoyed this comparison to Katrina from The Coming Disaster in the Derivatives Market:
In truth, many experts believe the derivatives market rests on a number of very precarious assumptions that have yet to be tested.And even then, the history of the derivatives market is replete with high-profile disasters. These include the 1994 bankruptcy of Orange County, one of California's richest, due to naïve investments in exotic derivatives; the 1995 failure of the 200-year old Barings Bank as a result of unauthorized futures and options trading by a rogue employee; the 1998 collapse of hedge fund Long Term Capital Management on the heels of ultra-leveraged bets gone wrong; and, the ongoing implosion at Fannie Mae, the nation's largest mortgage lender, because of derivative, accounting and other irregularities.
Up until now, none of these derivative-related hurricanes has breached the high-water levees of the U.S. and global financial systems. But as was the case with earlier, less destructive storms in the American Gulf Coast region, rather than decreasing the odds of a disaster, the relative calm of the past seemed to have inspired a false sense of security.
