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Default Swaps May Be Next In Credit Crisis
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The biggest Wall Street story most Americans haven’t yet heard of is the $62 trillion unregulated credit default swaps market.
Here is one scenario: A hedge fund buys insurance in case a company defaults on its bonds — a so-called credit default swap — when the hedge fund doesn’t necessarily own the bonds. Then it immediately shorts the stock, driving down the company’s share price, leading to a downgrade, and eventually triggering a default. It is the ultimate moral hazard, like taking out fire insurance for a home you don’t own: There is an obvious motivation to set the house on fire and collect the insurance.
Meanwhile, that same hedge fund may also be issuing its own credit default swaps, where it promises to cover a company’s bonds if it defaults, in exchange for the buyer of the swap paying out a premium. The premium is paid out in regular intervals, much like an insurance premium, and is a simple means for the hedge fund to generate additional income. This is especially true because the hedge fund does not have to put aside any capital to cover the swaps it is writing. Riskier still, no bond has to actually be delivered to settle the swap in case of a default.
“The credit default swap market is the ultimate bubble, and it is about to collapse,” the managing director of Institutional Risk Analytics, Christopher Whalen, said. “It is a Ponzi scheme, and is basically the same method as a bookie uses.”
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In the past, if credit default swaps were triggered by a default, a hedge fund would just write more swaps to cover it. But now the credit default swap market is largely frozen following the collapse of Lehman Brothers Holdings, which was an important player in the market. Making matters worse, the hedge funds that wrote these swaps never put aside any capital to cover them, so they are unable to pay and are liquidating their positions and closing.
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This is a frightening scenario. I haven’t heard yet of 62 trillion in outstanding grammswaps, but who can tell how many are out there? There is no list and no one in charge.
I hope you don’t mind, but I’ve posted your blog and the link to it at a new page I just created: http://www.cashmates.com/credit_default_swaps.html. I became aware of this diabolical instrument ‘of mass destruction’ over this weekend while listening to a Public Radio Broadcast (there’s a link on that page) which proved to be both one of the most illuminating… and therefore the most frightening… bit of financial education I’ve learned of in years. I, for one, don’t see the ‘bottom’ of this. It truly is “The Abyss”. I am in the process of dedicating Cashmates.com to FEARLESSLY discovering a solution… of uncovering a new paradigm for living with the reality of what unbridled greed on the part of few has done to the billions of “innocent bystanders”.. whose only fault and complicity seems to have been an excessive need for MORE… and for obtaining that more mostly on credit. I was once one of those people myself, so I know. But I also am somewhat of a ‘reformed junkie’ who has found, over the past half a dozen years, a ‘better way’. I humbly welcome anyone’s feedback and input… particularly POSITIVE input that can ultimately help alleviate the situation.