The market for credit default swaps is unregulated, untransparent, and highly dangerous. And its estimated worth is over three times the total value of US equities. “A CDS is a bit like a blind date,” says Andrew Snyder, “at first, they sound like a fantastic idea. But we all know differently.”

This from Today’s Financial News

We have all heard about credit default swaps and their responsibility in the current market crisis. But what are these mysterious banking creations? In this piece, I take a different approach to explain them.

Major economic downturns are caused by a combination of many factors, but every recession in the nation’s history can be associated to one deadly flaw, greed.

Throughout this country’s history, greed has tempted investors to take on huge piles of leverage. Eventually, the levels of debt grow to such huge proportions, the system that created it comes crashing down under its own weight.

It was massive amounts of investing on margin that kicked off the Great Depression. It was the sudden impact of massive deregulation that allowed banks to lend huge amounts of cash to just about anyone that caused the savings and loan collapse.

Now, it is the deleveraging of the credit default swap (CDS) industry that has the entire planet wondering where all its money went. Tens of trillions of dollars have been wiped from investor bank accounts.

Where there is a will, there is a way

During each of the nation’s major financial crises, we learned our mistakes, governments created new laws, and the markets moved on. The lessons learned and the rules implemented have kept us from making the same mistakes over and over, but they have not prevented us from going around the rules and creating new types of excessive leverage.

This is exactly what has happened in the CDS industry. These so-called insurance policies became so popular and so profitable for banks, hedge funds, and other debt-industry investors they could not get their hands on enough of them.

Unfortunately, many investors have a tough time grasping the default swap concept. They are unique investments that can become quite complicated. I will do my best to explain them and show how they got us to where we are today.

A CDS is a bit like a blind date. At first, they sound like a fantastic idea. But we all know differently.

Your buddy’s wife calls you up and says, “I got this fantastic girl I want you to meet. If you don’t like her, I’ll pay for your dinner and you can go home.”

What’s the worst that could happen? You get a free dinner, right?

You wish.

When the big date comes around you get another phone call from your so-called friend, “Sorry bud, we can’t make it to dinner with you and your date tonight. But we are going to send our other friends along.”

That’s not what you agreed to. But it is too late to back out.

Next thing you know, you are at a cheesy Japanese restaurant with some guy in a goofy hat throwing shrimp in your mouth. Your date is a cross-eyed parolee that has been eyeing your wallet all night. And your buddy’s friends skipped out before the first round of drinks arrived.

Credit default swaps are a tad more technical but they offer a pretty similar risk/reward ratio.

A CDS is nothing more than an insurance policy on debt. If the person owing the debt fails to pay it back, the insurance kicks in and the policy seller pays you what is owed. All that you have to do to get the coverage is pay regular premium payments, just like nearly every other type of insurance.

A betting man’s insurance

For example, let’s say you bought a General Electric (NYSE:GE) bond. Its face value is $1,000 and it promises to pay 5% annually. You are not so sure the company will be able to pay you the money when it comes due, so you call up Lehman Brothers to buy insurance on the bond.

Lehman Brothers (NYSE:LEH) checks GE’s credit rating and default history and tells you it will insure the debt for a two percent premium. You lose a few percentage points on your annual yield but have a guaranteed payout. Lehman Brothers gets a nice stream of cash flow and has little default risk.

You purchased a CDS and effectively “swapped” the risk to Lehman Brothers.

Basically, both sides of the party just agreed to go on a blind date thinking they were being set up with the blonde cheerleader captain they remember from high school.

We all know blonde cheerleaders never need to be set up on blind dates.

The problem continues to get worse. As a bond holder, you can sell your bond at anytime. You can also sell your default insurance at anytime.

The insurance issuer can also sell the policy and its associated cash flows anytime it wants. This would be the equivalent of your friend exchanging your blind date during the middle of dinner.

The CDS market was entirely deregulated in 2000 (under the watchful eye of Slick Willy, mind you), so just about anything goes.

Let’s go back to our GE example. Imagine your thoughts of GE’s default woes go away and you no longer want to pay premiums on an insurance policy you will not need. You sell the insurance policy to a friend but kept the GE bond.

If the bond goes into default, you do not get the payout, your friend does. But he has to figure out who is now the insurer. After all, Lehman Brothers has the right to sell the policy as well. It could have sold the note and the associated cash flows the minute you signed the contract.

Who knows who owns the contract now? It could have changed hands over a dozen times. (The average CDS is sold over ten times.)

Imagine walking into a restaurant filled with women. One of them is your blind date. When you ask which one is Amy, if you are good-looking they will all raise their hands. If you are not-so-hot, you won’t see a single hand go up (ask me how I know).

It is the same in the CDS market right now. Nobody wants to claim ownership or fair values on their books. It is because the banks are all over-leveraged and cannot afford to pay as company after company defaults on their debt.

We need more regulation?

The lack of regulation in the market gets worse, though. Any bank, hedge fund, or other investor can create these insurance policies. Over the past two decades, they were extremely lucrative sources of premiums and cash flows. As long as the economy was soaring and defaults were low, everybody wanted in the market.

In other words, as long as curvy good-looking women were going on blind dates, every guy wanted to go. Unfortunately, we all know there are a lot of fish in the sea and not all of them are model material.

Back in the CDS world, it is the same deal. During the peak of the CDS industry in 2007, over $45 trillion worth of swaps were on the market. It is a ludicrously huge number that is nearly three times the value of the entire American equities market.

Suddenly, companies started to default and insurers suddenly had to pay on their debts. It drained them of huge amounts of cash. A company like GE could have $100 million of debt on its books, but banks were selling tens of billions of dollars worth of insurance on it. After all, the more they sold, the larger the bottom line.

Who knew the economy would slow, companies would default, and insurers would be forced to cough up billions of dollars they do not have? Don’t answer that.

The CDS market created incredible financial leverage. It was a great tool when the economy was trending upward, but now that growth has slowed and so-called insurers are forced to make good on their multi-trillion promises, swaps are not nearly as dreamy as they once appeared.

It is as if the market tried to go on too many blind dates at once. Eventually, the CDS market got caught and now all of its potential suitors are slapping it with their purses.

A serious matter

Obviously, credit default swaps are much more complicated then I make them out to be, with issues like transparency, pricing, liquidity, and regulation all playing a monumental role in their demise. History will show they were just one more mistake caused by greed and overleveraging.

Later today, the last of Lehman Brother’s credit default swaps will be auctioned off to the market. They will be sold for a fraction of their previous values.

Instead of a blind date, it will be a public date auction. The market will be able to see what it is getting before it opens its checkbook.

The CDS market has learned its lesson. Trading practices are being questioned. Valuations are created differently. And regulators have finally realized how deadly these huge leveraging creations can be to the free market.

It may have been a multi-trillion dollar date gone bad, but we learned our lesson and must move on. Once all this blows over, the equities market will be a safer place for your money than it was a year ago.

Source: Credit Default Swaps: A Blind Date Goes Wild