Disclaimer - I didn't understand CDS's that well before, and although I now think I have a basic conceptual grasp of them, have much more to learn. In the midst of my anger over the nationalization of key sectors of our economy, and the refusal of all politicians and their lackeys to let the free market cut out the cancerous tissue - I came across this excellent (IMO) article, and reading it was cathartic. Maybe it will have the same beneficial effect for you. The Real Reason Behind the Global Financial Crisis by: Money Morning posted on: September 19, 2008 | about stocks: AIG By Shah Gilani [Part I of a three-part series looking at how so-called âcredit default swapâ derivatives could ignite a worldwide capital markets meltdown] Are you shell-shocked? Are you wondering whatâs really going on in the market? The truth is probably more frightening than even your worst fears. And yet, you wonât hear about it anywhere else because âtheyâ canât tell you. âTheyâ are the U.S. Federal Reserve and the U.S. Treasury Department, and they canât tell you whatâs really going on because thereâs nothing they can do about it, except what theyâve been trying to do - add liquidity. At the exchange rate Wednesday, 35 trillion British Pounds was equivalent to U.S. $62 trillion (hence, the 35 trillion pound gorilla). According to the International Swaps and Derivatives Association, $62 trillion is the notional value of credit default swaps [CDS] out there, somewhere, in the market. This isnât the first time Money Morning has warned readers about the dangers of credit default swaps. And it wonât be the last. The Genesis of a Derivative Boom In the mid-1980s, upon arriving in New York from Chicago with an extensive background in trading options and futures (the original derivatives), I was offered a job at what was then Citicorp [todayâs Citigroup Inc. (C)]. The offer was for an entry-level post in the bankâs brand new OTC (over-the-counter, meaning not exchange traded) swaps and derivatives group. When I asked what the economic purpose of swaps was, the answer came back: âTo make money for the bank.â I declined the position. It used to be that regulators and legislators demanded theoretical, empirical, and quantitative measures of the efficacy of new tradable instruments being proposed by exchanges. What is their purpose? How will they benefit the capital markets and the economy? And, what safeguards will accompany their introduction? Not any more. In the early 1990s, in order to hedge their loan risks, J. P. Morgan & Co. [now JPMorgan Chase & Co. (JPM)] bankers devised credit default swaps. A credit default swap is, essentially, an insurance contract between a protection buyer and a protection seller covering a corporationâs, or sovereignâs (the âreferenced entityâ), specific bond or loan. A protection buyer pays an upfront amount and yearly premiums to the protection seller to cover any loss on the face amount of the referenced bond or loan. Typically, the insurance is for five years. Credit default swaps are bilateral contracts, meaning they are private contracts between two parties. CDSs are subject only to the collateral and margin agreed to by contract. They are traded over-the-counter, usually by telephone. They are subject to re-sale to another party willing to enter into another contract. Most frighteningly, credit default swaps are subject to âcounterparty risk.â If the party providing the insurance protection - once it has collected its upfront payment and premiums - doesnât have the money to pay the insured buyer in the case of a default event affecting the referenced bond or loan (think hedge funds), or if the âinsurerâ goes bankrupt (Bear Stearns was almost there, and American International Group Inc. (AIG) was almost there) the buyer is not covered - period. The premium payments are gone, as is the insurance against default. Credit default swaps are not standardized instruments. In fact, they technically arenât true securities in the classic sense of the word in that theyâre not transparent, arenât traded on any exchange, arenât subject to present securities laws, and arenât regulated. They are, however, at risk - all $62 trillion (the best guess by the ISDA) of them. Fundamentally, this kind of derivative serves a real purpose - as a hedging device. The actual holders, or creditors, of outstanding corporate or sovereign loans and bonds might seek insurance to guarantee that the debts they are owed are repaid. Thatâs the economic purpose of insurance. What happened, however, is that risk speculators who wanted exposure to certain asset classes, various bonds and loans, or security pools such as residential and commercial mortgage-backed securities (yes, those same subprime mortgage-backed securities that youâve been reading about), but didnât actually own the underlying credits, now had a means by which to speculate on them. If you think XYZ Corp. is in trouble, and wonât be able to pay back its bondholders, you can speculate by buying, and paying premiums for, credit default swaps on their bonds, which will pay you the full face amount of the bonds if they do actually default. If, on the other hand, you think that XYZ Corp. is doing just fine, and its bonds are as good as gold, you can offer insurance to a fellow speculator, who holds the opinion opposite yours. That means youâd essentially be speculating that the bonds would not default. Youâre hoping that youâll collect, and keep, all the premiums, and never have to pay off on the insurance. Itâs pure speculation. Credit default swaps are not unlike me being able to insure your house, not with you, but with someone else entirely not connected to your house, so that if your house is washed away in the next hurricane I get paid its value. Iâm speculating on an event. Iâm making a bet. The bad news is that there are even worse bets out there. There are credit default swaps written on subprime mortgage securities. Itâs bad enough that these subprime mortgage pools that banks, investment banks, insurance companies, hedge funds and others bought were over-rated and ended up falling precipitously in value as foreclosures mounted on the underlying mortgages in the pools. Whatâs even worse, however, is that speculators sold and bought trillions of dollars of insurance that these pools would, or wouldnât, default! The sellers of this insurance (AIG is one example) are getting killed as defaults continue to rise with no end in sight. And this is only where the story begins. The Ticking Time Bomb What is happening in both the stock and credit markets is a direct result of whatâs playing out in the CDS market. The Fed could not let Bear Stearns enter bankruptcy because - and only because - the trillions of dollars of credit default swaps on its books would be wiped out. All the banks and institutions that had insurance written by Bear would not be able to say that they were insured or hedged anymore and they would have to write-down billions and billions of dollars in losses that theyâve been carrying at higher values because they could say that they were insured for those losses. The counterparty risk that all Bearâs trading partners were exposed to was so far and wide, and so deep, that if Bear was to enter bankruptcy it would take years to sort out the risk and losses. That was an untenable option. The Fed had to bail out Bear Stearns. The same thing has just happened to AIG. Make no mistake about it, thereâs nothing wrong with AIGâs insurance subsidiaries - absolutely nothing. In fact, the Fed just made the best trade in its history by bailing AIG out and getting equity, warrants and charging the insurance giant seven points over the benchmark London Interbank Offered Rate [LIBOR] on that $85 billion loan! What happened to AIG is simple: AIG got greedy. AIG, as of June 30, had written $441 billion worth of swaps on corporate bonds, and worse, mortgage-backed securities. As the value of these insured-referenced entities fell, AIG had massive write-downs and additionally had to post more collateral. And when its ratings were downgraded on Monday evening, the company had to post even more collateral, which it didnât have. In short, what happened in one small AIG corporate subsidiary blew apart the largest insurance company in the world. But thereâs more - a lot more. These instruments are causing many of the massive write-downs at banks, investment banks and insurance companies. Knowing what all this means for hedge funds, the credit markets and the stock market is the key to understanding where this might end and how. The rest of the story will be illuminated in the next two installments. Next up: An examination of the AIG collapse, followed by a look at how bad things could get, and what we can do to fix the problem at hand. So stay tuned.