Here's a brief explanation of what is happening on Wall Street - way beyond simple house mortgages....
Few Americans have heard of credit default swaps, arcane financial instruments invented by Wall Street about a decade ago. But if the economy keeps slowing, credit default swaps, like subprime mortgages, may become a household term.
Credit default swaps form a large but obscure market that will be put to its first big test as a looming economic downturn strains companies’ finances. Like a homeowner’s policy that insures against a flood or fire, these instruments are intended to cover losses to banks and bondholders when companies fail to pay their debts.
As the graphics explain, counter-party risk is an ever present factor.
What's truly astonishing is the size of this market: The market for these securities is enormous. Since 2000, it has ballooned from $900 billion to more than $45.5 trillion — bigger than the US equity markets, US Treasuries, and Mortgage Securities -- COMBINED.
CDS are thinly traded, have huge counter-party risk, are difficult to analyze, and are unreguylated insurance products. This leads me to this money quote:
"As with other securities that trade privately and by appointment, assigning values to credit default swaps is highly subjective. So some on Wall Street wonder how much of the paper gains generated in these instruments by firms and hedge funds last year will turn out to be illusory when they try to cash them in."
Keep in mind that the purchaser of a Credit Default Swap does not have to own the underlying securities.
New estimates put the volume of Credit Default Swaps at $62.2 Trillion.
SEC chairman Christopher stated just recently...
"Economically, a CDS buyer is tantamount to a short seller of the bond underlying the CDS," said Cox. "Whereas a person who owns a bond profits when its issuer is in a position to repay the bond, a short seller profits when, among other things, the bond goes into default. Importantly, CDS buyers do not have to own the bond or other debt instrument upon which a CDS contract is based. This means CDS buyers can 'naked short' the debt of companies without restriction."
Therefore, there are people and entities out there, in a big way, that since 2001 have been purchasing CDS's, even when they don't own the targeted securities - betting that those securities will default or the company involved with go bankrupt. The bankruptcy of Lehman Brothers, a major issuer of credit default swaps, combined with the government takeover of AIG, which had covered more than $440 billion in bonds with credit default swaps, has raised serious concerns about the default of the default swaps themselves.
Basically, we may be doomed.
Credit Default Swaps
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