Those watching news of the financial crisis, the bail-out, the failure of news of the bail-out to unfreeze credit markets, and HOPING that the G7 come out with SOMETHING the market will be happy about are becoming familiar with one of the major underpinnings of the problem: credit default swaps.
I missed the 60-Minute segment on AIG and credit default swaps, but have found some interesting information, if anyone wants to read up.
Here is the background on them - JP Morgan "invented" CDSs as we know them, and was responsible for creating the market for them as we know it today: The Monster That Ate Wall Street: How 'credit default swaps' - an insurance against bad loans - turned from a smart bet into a killer
A great article that explains the leverage in he credit default swap market and why a $5 trillion loan market can now mean a $50 trillion collapse: Credit Default Swaps: a $50 Trillion Problem
(MoneyMorning.com - written April 2008)
The problem was - they weren't insurance, they weren't equity, they weren't bonds - they were "derivatives." So the SEC says it had no supervision of trading in credit derivatives: the Commodities Futures Trading Commission (CFTC) said it wasn't responsible for oversight - and the International Swaps & Derivatives Association (ISDA) said "the industry can police itself." And of COURSE no insurance regulations applied to them - they weren't technically insurance.
Interestingly, a lot of insider trading that couldn't take place in the equity market or bond market apparently took place in the credit default swap market: Hedge funds accounted for 32% of credit default swap sellers and 28% of buyers (in 2006) according to the British Bankers' Association - 2nd to banks in each category. Pension funds and mutual funds made up 7% of the sellers and 4% of the buyers. Potential for abuse of credit-default swaps may lead to regulation
(International Herald Tribune, October 2006) ...unfortunately it didn't
As to AIG, the above article (page 2) says,
|The reason the federal government stepped in and bailed out AIG was that the insurer was something of a last backstop in the CDS market. While banks and hedge funds were playing both sides of the CDS businessâ€”buying and trading them and thus offsetting whatever losses they tookâ€”AIG was simply providing the swaps and holding onto them. Had it been allowed to default, everyone who'd bought a CDS contract from the company would have suffered huge losses in the value of the insurance contracts they had purchased, causing them their own credit problems.
So basically AIG was selling the swaps and not buying them. They were on just one side of the trade, so when bonds started defaulting because of the subprime ess, AIG had to pay out - but had nobody paying them - because credit default swaps do NOT work like insurance where, if your models are right, you've got more premiums coming in that insurance you're paying out. If you're just issuing credit default swaps and not selling them - there's no other side to that coin!
The problem is that the market was so lucrative for so long, if companies able to didn't participate, the performance of those companies would likely have lagged their peers - and CEOs, ironically, would have been fired.
Like so many of us have been saying, there's plenty of blame to go around. While Clinton and Greenspan may have been responsible for creating the environment that led to the greatest housing bubble ever, Bush and his admin can be blamed for never dealing with regulation of the CDS markets, despite repeated warnings.