Credit Default Swaps for dummies - informational only

Credit default swaps have been around for many years. The author's description of how fictitious profits are recorded for them seems correct. Most insurance carries reserve requirements; credit default swaps do not. Most insurance cannot be purchased by someone not involved in the contract; credit default swaps can.

Here's the pernicious part: effectively, I can buy an insurance contract against your house burning down, and if it does - though I have no interest in your house - I get paid. That gives me quite the incentive to burn your house down.

That said, I don't believe the doom-and-gloom scenario of the author. He sounds like a survivalist.

Steve, he seems to think AIG was the linchpin, not Lehman. You've focused on Lehman. What do you think of that portion of his analysis? It seems central to his premise regarding the cause of the crisis.

The CDS market and AIGs participation in it is certainly was an important piece among many that allowed the formation of the crisis, whereas the Lehman bankruptcy filing set us on a particularly nasty path toward its resolution. In hindsight, allowing Lehman to fail is not looking like a very good decision at all. In all fairness, though, I don't see how you could have gotten the political concensus to continue to prop up bank after bank (as well as AIG, which the treasury did a quick turnaround on after Lehman) without some concrete demonstration of the severity of the situation, which Paulson got in spades after the bankruptcy filling.

For a glimpse into the world of CDS check out http://www.nytimes.com/2008/06/01/business/01gret.html which tells the fascinating tail of UBS entering into a bespoke swap insuring a 1.31 billion CDO with a hedge fund having all of 200 million in assets. I looks to me like the hedge fund got one of those letters from Nigeria where UBS needs a respectable hedge fund to give some money to so that they can get the risk off the books and that they will mark to "subjective" (wink wink), but at they end of the day they want to take your 200 million too.

The lehman CDS crisis has passed and been taken care of. The trillion dollar plus CDS crisis for GM , Ford etc. has just begun.

GM and Ford re steadily running out of money and thanks to the credit agencies it is too exspensive for them to issue debt in order to recapitalize. There are only 2 ways this ends:

GM , Ford will be bailed out by the federal government...if they file for bankruptcy there is no way in hell the people who insured the CDS will be able to pay out 1 trillion plus in insurance to those who purchased credit default swaps.

the other scenario that is making the rounds is that Uncle Sam would invalidate any payment to those who owned CDS on GM or Ford without actually owning the stock. It is sort of a variant of only being able to purchase an insurance policy on the life of someone you actually have some tie to. For e.g. I cannot purchase a life insurance policy on Stevehjx life ...I have to show some way I would be damaged if he died to get a payout. This scenario is gaining a lot of traction not only b/c of its logic when you compare it to life insurance but it also gives a FAT FUCK YOU to the Hedge funds and speculators that would be destroyed under this scenario. A Win win shall we say for the populist movement

by the way...just b/c Steve was loudest person arguing that NY real estate would fall (there were a lot of people on this blog who were here earlier saying the same thing) does not make him some sot of Nostradamus that knows all.

I'm sorry to say that anyone who did not know where real estate was going was just plain stupid and should limit their intake of kool aid. Never has there been a more obvious ending...I mean our grnadchildren will be asking things like "don't people know that what goes up Always goes down"

The sad thing is that in another 30-40 years there will be some other massive bubble and there will be clowns explaining why this time its different

I think the ability to go short is as valuable as the ability to go long. That's all CDS' are - shorts. We allow 'em on equity; why not on debt? Maybe they need to be better regulated - i.e., you can't write coverage you can't cover. Then again, anyone buying a swap should have assessed counterparty risk.

"I'm sorry to say that anyone who did not know where real estate was going was just plain stupid and should limit their intake of kool aid. Never has there been a more obvious ending"

- Well I completely agree and invested accordingly since 2003 (first shorting homebuilders, then selling my condo to rent until prices came in), but understand that most of the world, including some very wealthy, intelligent, and experienced investors, drank that kool-aid.

"The sad thing is that in another 30-40 years there will be some other massive bubble and there will be clowns explaining why this time its different."

- That's not a sad thing; that's an opportunity to make money. The smart money can only really score big if there is a "not so smart" money. If you had enough foresight in early 2000 to say "stocks are trading at 33X earnings? Time to short!" or in Jan 2008 "The fed has cut has cut 5X in 4 months; the party is nearly over", you'd have really made out. I'm not a big market timer and can't tell you if we're on the third leg of an Elliot wave, but I can spot big, seismic changes where fundamentals are out of whack. If you can't tell the business cycle is ending when the fed cuts every mtg for months, if you can't tell stocks are overvalued at 33X earnings or Real Estate is overvalued when it has returned 15%/yr for 5-6 yrs while incomes only grew 3% a year...well, that must be some really great Kool Aid!

If you believe in the Eliot Wave theory clearly we are in I think a Wave 3. We just experienced the the 3rd down leg which means we've got some upside coming. That will only be temporary until the final 4th leg down comes which could result is a low like S&P 600. If the Wave theory holds true we could witness a situation after the final leg down where a lot of people want nothing to do with stocks.

Admiral the US can't keep functioning this way...no empire lasts forever...don't you notice that each crisis gets more severe. Eventually the US will bankrupt itself if they don't stop and learn. Remember the Mayans ruled for close to 2000 years but even they destroyed themselves.

"That will only be temporary until the final 4th leg down comes which could result is a low like S&P 600."

Unlikely with all the money that's circulating in the economy right now.

IF YOU BELIEVE in the Wave theory, then we have another final leg to go down. S&P 600 is only 20% or so down where we closed on friday, so it is not an impossibility. We should all be in the habit of listening to the impossible.

You of all people know you cannot reinflate a bubble.

"Remember the Mayans ruled for close to 2000 years but even they destroyed themselves."

Yeah, but they had some really cool festivals first, with human sacrifices and all!

We could have human sacrifices on StreetEasy, btw. Virtual ones, of course. Everyone think of the most obnoxious realtor you've ever been involved with and throw him or her on the fire. Limit two per customer...

"You of all people know you cannot reinflate a bubble."

If stocks are trading at 12x earnings instead of their usual 18x earnings, that is not a "bubble."

Is there any way to "undo" the Lehman bankruptcy? For them to say, hey, the government is now bailing out these bad assets and it turns out we're not insolvent after all?

Yog: "It was all a dream ..., just a very bad dream ..."