Ideas and Opinions from Donald Trump and TrumpU Faculty.
Credit-Default Swaps: Understanding the Debacle
Before last month, you probably had to be in the trenches of the financial sector to have known anything about credit-default swaps. That’s why it comes as a huge surprise to find out that there’s been a 55 trillion dollar dirty, little secret on Wall Street. It’s almost unfathomable that these types of hedging practices could have brought down some of the largest and oldest financial institutions in our nation’s history... and most of us didn’t even know they existed.
A CDS contract involves the transfer of the credit risk of municipal bonds, mortgage backed securities, or other corporate debt between two parties. It is something akin to insurance because it provides the buyer of the contract, who often owns the underlying credit, with protection against default, a credit rating downgrade, or another negative "credit event." They don’t exactly call it insurance so as to avoid the regulatory agencies involvement.
So, when the subprime mortgage crisis occurred last year and those CDS contracts were being redeemed at the rate they were, the insurance companies who issued them didn’t have the money in reserves to cover those losses. The ripple effect has been felt around the world at this point and is now become a tidal wave of financial uncertainty to nearly ALL of the stock exchanges in the world!
I am a large proponent of letting the capitalism and free markets run themselves for the most part. But as a taxpayer, if we are ultimately going to be paying the price and having to cover the losses when they occur, then regulation HAS to occur. Many people lost everything they had in terms of retirement savings and personal portfolio value and are at a point in their lives that they no longer have the earning capacity to recover. It’s criminal in my estimation what has happened and I hope the “perps” are brought to justice.
Are there other types of practices going on that present these types of risks to us?
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1 Comment
My understanding of Credit Default Swaps (CDS), which I have been following for years, is different.
Please correct me if I am wrong. The reason they are called CDS is that these products (derivative) sound like insurance contract but in reality they are not. These products do not have to follow any of the rules of insurance company.
For instance when an insurance insures a home and the home burns down, the insurance pay the claim and the money comes from other home owner premium whose house did not burn down. It is a sound insurance because when a home burns down, it is unlikely that other homes will not burn down at the same time.
A CDS is different, because when there is a panic all of a sudden the rate of default increases exponentially
In addition, CDS are packaged with other securities and are sliced and diced and resold 1000 of time to wall street, and when it is time for the CDS to pay a claim, it is hard to know who is the responsible party, and often the responsible party is insolvable (Remember it is not a real insurance contract, as a matter of fact purposely you will not see the term insurance in a CDS contract).
So Banks (which profits from closing costs with their mortgage broker and Lawyers) have no incentive check who the borrower is, all they did was to collect the closing costs (fees and all) and package these loan, (i.e. not service them and not taking any risks) and dump them after being packaged with CDS to Wall street (i.e. our IRA and other retirement plans).
Now these banks are asking for a bail out.
My solution to the problem:
1-Change the CDS into a real insurance product, which has to follow all the rules and regulations that insurance, companies use.
2-Give the bail out to the Tax payer directly in the form of a debit card where only American Made product can be purchase, and let the tax payer choose if they want to purchase a GM product or a Toyota made in the US.
The problem is that the derivative market is so complicated and convoluted (like a bag of Pretzel (Confucius), and in addition the value of these derivative are intertwined and inter-variable that very few very sophisticated people understand the real value of securities anymore, even real estate.
In contrast when JP Morgan asked the banker to give them their Books, it was easy for Mr. Morgan to look at the assets and liabilities.
in 2009 it is a very different story.
DB