Credit default swaps were seen as easy money for banks when they were first launched more than a decade ago. Reason? The economy was booming and corporate defaults were few back then, making the swaps a low-risk way to collect premiums and earn extra cash. The swaps focused primarily on municipal bonds and corporate debt in the 1990s, not on structured finance securities. Investors flocked to the swaps in the belief that big corporations would seldom go bust in such flourishing economic times.

The CDS market then expanded into structured finance, such as CDOs, that contained pools of mortgages. It also exploded into the secondary market, where speculative investors, hedge funds and others would buy and sell CDS instruments from the sidelines without having any direct relationship with the underlying investment. “They’re betting on whether the investments will succeed or fail,” said Pincus. “It’s like betting on a sports event. The game is being played and you’re not playing in the game, but people all over the country are betting on the outcome.”

Any- and everyone can bet on this ‘game’s’ outcome and that is what balloons the notional value of the market. But, note, while the notional value is large, Mark Wadsworth is right — the contracts all net to zero.

The next big CDS auction, BTW, is for WaMu on the 23rd of Oct.

I am beginning to understand your explanations of the CDS situation. All the dumbing down in the mainstream media doesn’t really help much and is rather condescending. Even the PBS explanation glossed over the mass destruction aspect, the mechanism behind which Hirsch attempted to explain in his video.

An initial trigger, defaults in mortgage backed securities say, causes payouts on associated CDSs. The resulting down rating forces the insurer to back their remaining CDSs with more assets. Those without enough assets go under, causing those CDSs to “disappear in a puff of smoke”. The risk that they had carried instantly gets transferred back to the insurees who get spooked and start dumping the bonds for which the CDS had originally been agreed. This triggers further credit events that force more insurers to payout, get downrated, put up more assets to back their remaining CDSs, making the insurer more at risk of “disappearing in a puff of smoke”. The downward cycle then self sustains. Bonds get dumped along with many other asset classes. And since private banks are themselves heavily exposed to the CDS market, they stop lending to each other and cease to perform their function of turning the central bank’s short term loans into long term capital for main street business.

Am I understanding this correctly?

Imagine you are a bank and I am a bank. Say you have a bond that pays you a good return but you’re worried the company is riskier than people think. So you strike a deal with me where I say I’ll take that bond off your hands if the bond goes bad for a price. You’ll get your money back and I get the bond.

Great!

The problem is that the contract we make is non-standard in terms of maturity, amount, and other key features. It’s just a specific deal between you and me. That means, as you say, it’s not fungible.

But, everybody’s doing it. Just because the individual contracts are not fungible any more than the insurance on my car or my boat or my house is fungible doesn’t mean it’s not big business. These individual contracts are plentiful but not necessarily fungible. Again, thinking of them as insurance, you can understand that they are specific to specific circumstances and non-fungible.

Now, Mark Wadsworth thinks that’s no big deal. It certainly is no big deal in normal insurance. But, it is a big deal in Catastrophe insurance.

http://en.wikipedia.org/wiki/Catastrophe_bond

And the same problems there are inherent here:

“Michael Moriarty, Deputy Superintendent of the New York State Insurance Department, has been at the forefront of state regulatory efforts to have U.S. regulators encourage the development of insurance securitizations through cat bonds in the United States instead of off-shore, through encouraging two different methods — protected cells and special purpose reinsurance vehicles.”

The point being that single event losses could be so large as to wipe out the insurer of the bond. That’s not the case in normal insurance. This is the problem with the CDS market in my opinion. Single events can wipe out the insurer, setting off a potential cascade of problems as that insurer is also party to a number of other large private transactions which effectively become null and void when the insurer goes bankrupt.

Is this a problem? Maybe. I think it needs to be regulated. Mark says no. The risk is overblown. There you have it.

Unfortunately, if it weren’t for recent videos such as Paddy Hirsch’s CDS tutorial, I wouldn’t have made it past the first sentence in the wikipedia article. No offence intended to the blogger, but this explanation is still only a marginal improvement.

I’m confused how the CDS can both be illiquid (cannot be exchanged for other CDS derivatives — does that mean not fungible?) and yet it ends up being “the most widely traded credit derivative product”. How did such an illiquid product get to become so popular?

Also, was there anything in Hirsch’s whiteboard tutorial fundamentally flawed? Did he leave anything crucial out?

Given what is happening, it is crucial that the often impenetrable world of global finance be laid out for the public in more easily understood terms, now more than ever. Otherwise you risk alienating those layman (like me) who are searching for answers in the wake of economic shocks that destroy one’s prior view of the world. They are left vulnerable to possibly harmful ideologies and will end up choosing the answers that are most easily assimilated, exploiting inherent fears, biases, and prejudices.

Exactly. It is something that the powers that be should be aware of – possibly even concerned about – but CDS themselves are not particularly important in the grander scheme of things. They all net off to NIL and will disappear in a puff of smoke.