How the dominoes fall - credit default swaps and their severe danger

I've been trying really hard to understand exactly how all the banks and sovereign debt issues coming not only from Greece, but potentially from all the other Mediterranean troubled countries are linked, and I think I finally get it. I couldn't understand why Germany and other countries would continue to be involved in this mess, but just as the US was drawn into TARP because of our bank exposure, my understanding is the same thing is happening here.

For all the threats talked about here, I really don't think the derivative market and credit default swaps are given nearly enough attention. I'm not an economist or financier, but my understanding is the derivative market is where you are essentially betting on whether a given economic factor or item will go up or down. To insure bets from this market, credit default swaps are the insurance on the bets, saying the issuer will provide money if the venture fails.

But, the nasty thing about credit default swaps that seems to be the key factor behind the 2008 US crisis, and the impending 2011 Euro crisis (which will go global quickly), is that you don't have to be a stakeholder to make the bet that something will fail. The movie "Inside Job" did an excellent job of describing what happened in the US where Goldman Sachs, amongst others sold bad mortgages (bundled as CDOs - collateralized debt obligations) making money on the front end, and then bet they would default making money on the back end, largely off AIG. Of course, AIG couldn't cover the bets because the smart money knew the failure was coming, and so it crashed and was saved only by the intervention of the central bank, the Fed, who through a combination of taking taxpayer funds and inflating the currency, covered Sachs' and others margins.

Make that simpler. A company sold bad products, bet on them to fail, and then was paid by the government when it failed at expense to the people they fleeced. Outrageous. But the system hasn't changed in any meaningful way, so the betting continues through today.

Now, we face Greece which presents the same basic problem. I've read article after article trying to figure out all the players, but the short version is the European banks are scared to death of the inevitable Greek default because of all the bets on these credit default swaps. The theory in allowing them seems to have been while some would bet things would work out, others would bet they would not, and the rate of payment on them reflected the relative risk. But what happens when everyone's bets fail, as they probably will (given that one year bonds in Greece are now trading at 150%, a sure sign of their insolvency) and the triggers kick in that force payment of those swaps. The banks or institutions holding them will be unable to pay.

What makes this market even more deadly is just how far institutions have been able to leverage themselves to play. With notional investment sometimes thirty times greater or more than actual collateral being held, it wouldn't take much to tip the first domino.

Put more simply, it's as if you or I made thirty different bets with the same dollar, saying "Well, since they're a little better than fifty/fifty anyway, it'll all work out in the end." Banks make a ton of money when it does, creating capital basically out of thin air for their investments and balance sheets, but what would get one of us beat up has a deadly side effect for them. What if they lose? Then, they don't just lose their shirts, but they end up owing as much as thirty times the amount they possess!

So the real question becomes who holds these Greek credit default swaps, and how bad is the exposure? Because if it is more than the banks holding it can pay, who from my research appear to be French and German (though there are many others linked), those banks may well be unable to meet their obligations when Greece falls. And then, the panic sets in, and as the banks draw on other banks and other bets come into play, the same chain that made everyone money will lose everyone money.

Here's a scary thought for you. The global annual gross domestic product is in the neighborhood of $65 trillion dollars. The global derivative market is, depending on who you read, at least ten times larger than that. Totally unregulated, but intertwined between every bank not just in Europe and the US, but the world.

So when the first domino is pushed, and Greece falls, the problem isn't Greece being broke or wasteful of money (though they certainly are) or Eurocrats trying to save their currency (though they would like that too), but it's trying to prevent the fuse from being lit on what I believe to be an unstoppable chain reaction that could potentially decimate the banking system.

Assuming there is enough money ponied up to cover the Greek default, and all the bets made against it (which to my mind is the craziest thing...how anyone can essentially get paid insurance for something they don't own!) are paid off, billions of dollars of wealth will have been lost causing a crippling recession, and that's the happy scenario. The unhappy scenario is a general default that begins in Greece, goes to Italy, Spain, and Portugal, and then takes down the French and the German banks as well. At that point, the UK and US investments get hit even harder, and so on.

If my explanation hasn't been the best in this area, I apologize in advance and say I've been struggling for weeks now to really understand this. I may not have the technical precision of others, but I do believe the basic scenario is I'm portraying is accurate, and should be much more frightening to most people than any foreign policy threat.

I am not a fan of central banks at all, but just think what would be the consequences of a global financial collapse where the different private banks became insolvent all at once?

For the United States is I've read 95% of these CDS's are held by just four banks: Bank of America, JP Morgan Chase, Goldman Sachs, and Citigroup. If this goes down in the bad scenario, they will be pushed to insolvency, and you have to ask yourself what will the Fed do?

what would the fed do..... print more money. lol

Easy to understand...nicely done! I've been trying to understand the derivatives and who will end up trying to cover the massive debt in the end game. Seems like no group of banks or even countries can prop up this scheme much longer. Let the bubble burst and look for survivors?

reply to post by cassandranova


S&F to you for taking the time to understand these critical issues. I myself struggle to understand it in its entirety but I too make an effort to figure out this mess of a financial system. I think your post does a good job of simplifying things. I don't think enough people understand how things have been operating all these years. And I think it is a safe 'bet' that more people would be even more ticked off if they understood it better.

The surprising thing is when you read documents written immediately after the housing crisis, many people suggested one of two reforms (or both) on the national level.

1) Regulation of credit default swaps to prevent people from engaging what most would consider unethical behavior such as betting on your product to fail.

2) Limiting the amount of exposure by the investment banks by limiting their leverage and increasing their required capital holdings.

Instead, neither of these was done as Paulson chose a third path. Invest taxpayer money into the banks, and by the extension, into the game. The reason for this goes beyond simple corruption. It's true that the taxpayer had a better chance of a return on investment this way and it prevented a painful reduction in a market that is very lucrative for finance, offering a win/win political solution. But, it also meant the exposure to any potential downswing in the future would be that much greater now.

reply to post by cassandranova


Don't forget separating investment and commercial banking services.

Commercial banking needs it's own set of simple reforms as well. 20% loan to value down payment requirements. If you can't pay down 20% of the loan you can't afford the loan, that means no loan for you.

No more gambling with depositor money on Wall St.

Basic Glass-Steagall-like provisions that would go a long way toward protecting both the individual customer and the bank itself.

S & F. Good for you trying to actually understand this crap.

There was warning of this type of disaster back during the Clinton admin.. Brooksley born warned them all that the unregulated otc derivatives were a hazard to the economy. Greenspan, Rubin and Summers all sat in front of congress swearing that if the otcs were regulated, THAT would cause the crash.. well, needless to say, congress agreed with Greenspan. Fast forward to 2008, and we are in a crisis. It's not going to get better. There is too much stuff going on under the table and behind closed doors. And our "representitives" are wrapped around the bankers fingers because of he nice "donations" they receive. It's sick.

Nice post op. Glad to see some are researching

Excellent Post OP. You did an excellent job of defining the problem.
Not to take anything away from your post but a simple explanation is .....
Derivatives are items such as commodities and futures like Gold, Silver, Corn, Treasury Bills, etc...
Credit Default Swaps are insurance against you losing on anything and everything you can possibly imagine like mortgages, government and corporate bonds, commodities. No One, absolutely No One, has an idea of how much the CDS market exposure is. Some estimates go as high as $600 TRILLION dollars. Just try and comprehend that.

reply to post by cassandranova

...and you have to ask yourself what will the Fed do?

the European central bank will do just like the USA Fed Reserve did... bankroll the illegal banking activities by the Banks of issuing more CDS 's than they can cover when they become due & payable..
.the laundered term is 'over-leveraged'...but it ammounts to fraud plain & simple... the CDS paper will be worthless unless the ECB guarantees all those Default Swaps with taxpayer monies


The USA Federal Reserve pumped an estimated $20 Trillion back into the financial system/banks, both American and the dozens of European Banks that held that toxic paper created by the USA banks, who did not have enough collateral to pay off those 'bets' but managed to get' made solvent' because it would have meant the bankruptcy of every major (TBTF) bank in the USA----


the only way the EU central bank can escape a 'Lehman type event' is to negate all the Default Swaps that are above & beyond the issuers ability to pay-off as required.... the one way to do this is to make the Default a non-event or never meeting the legal trip-point of requiring a pay-off....
otherwise the EU central bank will have to create some $20 trillion themselves to bail out the system (just like the USA Federal Reserve had to do ~-secretly/clandestinely~)\
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the whole thing is too complex to give it a 50 world digested reply... so kindly overlook this post as an attempt to make clear the chicanery taking place & the repercussions down the road with the inflation/deflation collapses sure to happen.

We need to regulate the trades and making bets on your product to fail is illegal or should be. IMO anyone who went infront of congress and argued that the trading was regulated before the subprime issue should be arrested now for lying under oath with a healthy jail sentence. There should be examples made to discourage this kind of buy outs and corruption. Today are politians think there above the law some need jail time so the message is sent and are gov won't take a dime to look the other way again. The odds of them crooks passing that are slim 2 none.
Just think the euro collapse will make a select few richer than most countries. As much as I hate saying it we need to let the banks fail and pick up the pieces and learn from the mistakes. There needs to be a list of people who took everything in these corrupt games and the list should be posted everywhere. Make them squirm and embarrased but it won't matter they will buy a nice house in dubii and vanish from the wrath of the poor billions that will be effected when the system fails.

reply to post by warsight


Uh....what? Anyway...

I'm no Econ major, but it seems to me like there are really only 2 options here. 1.) Just let the whole damn thing fail so we can start rebuilding with better financial laws and practices ...or 2.) Continue to try to patch up the system, which requires yet even more fundamentally flawed "band-aids" to seal another crack in the dam.

For all you economist types...what is the solution? Is it too far gone...and if so...what do you think will happen if they continue to "band-aid" and bail-out the banks?

I'm not an economist, but I agree with the idea some regulation is needed. For instance, it strikes me as egregious to allow a company to buy insurance on a product it sold. There's a severe conflict of interest. But CDS's work usually on larger economic indicators.

I think the simplest way to solve this is to limit the amount of CDS plays that can be guaranteed by any one firm. If, for instance, you would need $1 in hard assets for every $5 you have bet, the diversity of bets and quantity of assets should be enough for banks to survive in any situation without need for government intervention.

Frankly, this should have been done in 2008 and the problem was well understood. It was also understood that this would reduce the profit margin in the sector by probably a factor of four (though still in the billions), and therefore was deemed detrimental to the economy.

On an unrelated note, I learned something potentially fascinating about the Greece situation. In the event they go to war and that is related to the default, the CDS's won't have to be paid. I have nothing to substantiate this, but coupled with the recent threads about the sale of several hundred tanks to Greece and fighting with Turkey over Cypriot resource development, if a war did break out there, the banks stand to save a trillion dollars in losses from their balance sheets.

I almost thought of making a new thread for it, but since it is tangibly related, we'll leave it here. I think the title of this is intimidating, but it shouldn't be. What we fear here is a run on the house. The systemic error is that some situations just can't be made into fifty/fifty propositions.