What is a credit default swap? Part I

In studying what brought our country to the precipice of doom (and indeed, what might push it over), I’m finding out about a monstrosity called Credit Default Swaps. I’ve heard about them for months now, but I decided to dig in today to find out what they mean.

I had no idea what these were. But you should since they will have direct consequences to your daily life. It’s a HUGE part of the mess we’re in.

For practical purposes, CDS’ are basically corporate life insurance. One company pays premiums to insure against the failure of another company. If the company goes bankrupt, the payer collects from the company who insured against failure.

The problem is that CDS’ aren’t regulated like life insurance. Nobody has to prove they have the money to insure. And there are no reporting standards. And from an accounting perspective they’re invisible. And anyone can insure or be insured against any company. So who knows who’s doing what?

Imagine that people could do this. You could go out and say “hey, why don’t you pay me 1 buck a month to insure that the president doesn’t die of food poisoning. If he does, then you get 500,000 dollars.” You’d probably get alot of takers because that’s a highly unlikely event. If you got 500 or so takers, that’s 500 ‘free’ dollars a month. Then what happens when the president actually dies of food poisoning?

Now pretend there are thousands of people in your town insuring against the president dying of food poisoning. And the governor dying in a car accident. And Miley Cyrus dying while skydiving. Before you know it there are countless contracts. And untold millions in insurance. And nobody knows what’s going on.

Then, come to find out the president really like oysters and raw chicken, the governor has a shadow life of illegal drag racing, and Ms. Cyrus was skydiving 30 times a day. They all tragically die, and all those people who had insurance want to collect.

It’s chaos. Nobody knows who owes who.

Will Mr. Johnson be able to pay off that truck he wants to buy? Or does he secretly owe more than his net worth on a Miley Cyrus tragedy?

Will Ms. Smith ever pay you that $500 she owes? Or did she bet on the governor? Better go collect ASAP. just in case.

This is exactly what happened, except it’s huge huge companies with Trillions of dollars at play. Who would have thought that some of the strongest institutions would go under due to mortgages?

But they did, and now all that unregulated and unquantified gambling/insurance is a huge question mark. Nobody knows who owes who.