A credit default swap (CDS) is nothing but a gamble between two people that a company or an individual, not necessarily connected with them. will get into financial trouble. Sears, for instance, sells stoves on long-term credit. Some purchasers might not be able to pay. So Sears finds someone else willing to pay the purchaser’s debt in case they fail to pay, that is default on their loan hence the term “credit default.” Sears pays a regular premium and gets a guarantee in return. In many ways this is very similar to buying fire insurance. The big difference is that we buy fire insurance for our own house from an insurance company. In a CDS, two people totally unrelated to you and quite unbeknownst to you are taking a bet that your house is going to burn down. In the case of Sears and the unknown bettor called a “counter-party” they are taking a bet that the buyer (the reference entity) will be unable to pay off the stove. The purchaser of the stove is totally unaware that Sears has taken out a bet of their ability to pay. Anyone can make this bet – not just Sears. Michael and I could take a bet that Sears is not going to be able to collect the money that’s owed to it. Bob and Joe can make a bet that California will be unable to pay its bills. The bets that folks around the world have now taken on other people’s houses burning down — or that another company or individual is going to run into financial trouble — now runs at over $54 trillion. That is more than twice the size of the American, Japanese and European economies put together.
This would not be so bad except that no-one knows who is betting and how much they have bet. Bobby and I can take a million dollar bet that GM and Chrysler are going to merge. If we assume that there is a 50/50 chance of this happening then I have a 50% chance of winning a million and a 50% change of losing a million. On average that bet is worth zero and that’s the number that the accountants will report. Nothing will go into the financial reports because accountants report averages only. But clearly a nothing for sure is very different from a million dollar profit on the upside and a million dollar loss on the downside. But accountants do not report risk and so we have no idea of just how much folks stand to win or lose, let alone who those folks are. Add to that the fact that if I lost, I could not possibly pay Bobby (read Iceland, which is now bankrupt and unable to pay its bets off.)
The nearest analogy that I can come to the present credit crisis is telling people that a bomb has been placed in a car in a parking garage. There is just one bomb. But whoever turns the ignition key in that one car is going to be blown to smithereens. Would you walk out and try the ignition in your car? And, so the cars don’t move and the shops begin to shut down and the police (read the government) has to move in to find that bomb and remove it (read bailout) to restore confidence in the rest of us that our cars are safe to drive. The good news is that when the bomb is found and removed, traffic should get back to normal pretty quickly. . . . Of course, in the meantime folks are sitting around making side bets on whether the bomb is in the red car or the blue!!!!
I should add that what makes the current situation even worse is that we no longer trust what the police (government) tell us. So, if they show up at a press conference and tell us not to worry, we’ve found the bomb, we still don’t believe them. This, as I never tire of saying, is at heart a moral crisis. We have been lied to by our leaders for so long that we no longer trust them to tell us the truth.