On Monday, October 6th, what may be the biggest test of our financial system to date will take place. Credit Default Swaps are in question here, and
these little-known, hard-to-understand, shadowy investment vehicles can potentially wreak more havoc than subprime mortgages ever did.
Credit Default Swaps, or CDS, are, in simple terms, a type of insurance against default on a debt. This is sort of similar to the type of insurance
you get for your car, though CDS are unregulated and privately traded between companies with very little public reporting of the money involved.
It's like a cross between car insurance and a side bet one might make with a friend - "I'll bet ya a hundred bucks you won't eat this bloated,
festering rat that's currently stinking up my basement!"
In the case of financial markets, a bank holding a bloated, festering rat of risky debt (something like a huge stack of subprime mortgages, perhaps)
would take out a private contract with another company whereupon the bank would pay the "Insurer" a percentage of their bad debt per year in
exchange for a promise that the "Insurer" will make a large payment to the bank if the bad debt defaults. This, in theory, would help the bank
mitigate their losses if/when the loans default. Much like you pay a quarterly premium to your car insurer in exchange for the promise that they will
buy you a new car if yours is destroyed by a falling piano, a bank pays that premium into a CDS with the promise that the "Insurer" will offset part
or all of any defaulted debt the bank may face in the future.
That seems harmless enough on the surface, doesn't it? Most of us do something kinda similar with car and health insurance.
Things start to get difficult, though. Imagine if your neighbor could issue an insurance policy on your car as well. Let's say he thinks you're an
excellent driver and that you would never get into an accident. He starts taking CDS contracts from others in your neighborhood where they pay him a
premium and he promises to buy them all new cars if you destroy yours. For a few years, your neighbor would be raking in the dough. If you never
destroy your car, he'll have made a ton of money from all these people betting that you're NOT a good driver. But, imagine one evening you decide
to take a joyride after imbibing a quart of moonshine and wind up turning your local movie theater into a drive-in - all the sudden your neighbor is
on the hook to buy all these other neighbors new cars because you went and crashed yours!
Replace "cars" with "toxic debt" and "neighbor" with "random speculator" and you've got the dark side of Credit Default Swaps.
The even darker side? The current estimate of the value of the CDS contracts out now - nearly $55 TRILLION.
Now that I've explained that, let's look at what is going to happen on Monday. A series of auctions will take place to determine the exact dollar
amount of loss in the failure of Fannie and Freddie. Once that dollar amount is established, the "Insurers" holding the Credit Default Swap
contracts must pay up, and they are most certainly expected to have to pay out in the BILLIONS. Private "Insurers" aside, the publicly traded banks
that "insured" Fannie and Freddie's debts in this manner will be looking at a huge outflow of cash.
Let's say Bank X is currently on shaky ground in the current economic environment. Their customers have been withdrawing money and closing accounts,
they have lost money due to their own dealings in toxic mortgages, and their stock value has declined drastically in the past month. On top of all
that, Bank X is the "Insurer" in many CDS contracts.
On Monday, Bank X will find out how much they owe on Fannie and Freddie's defaulted debt, and they'll have to pay up.
If Bank X cannot cover the "insurance" payouts on these Credit Default Swaps, Bank X will become insolvent and either file for bankruptcy or be
seized by the Fed.
It's unknown how many "Bank Xes" there are right now, but analysis indicates there are a good number.
Even if Bank X makes it through Fannie and Freddie, Lehman's CDS auctions will happen on 10/10 and WaMu auctions on 10/23. As Bank X fails, its CDS
auction will be scheduled, driving Bank Y into failure.
It's like a line of dominoes. One falls, more will fall behind it.
It should be clear later in the day Monday which banks, if any, will face potential insolvency due to their CDS obligations. On Tuesday, 10/7, we
could see the stock markets respond accordingly.
Don't clear out your bank accounts, but it's not a bad idea to have a few days' worth of cash on hand next week. It appears like we could possibly
face a bumpy, bumpy ride.
(visit the link for the full news article)
[edit on 10/4/2008 by anachryon]
Mod Edit: Title
[edit on 4/10/2008 by Badge01]