The Credit Default Swap (CDS): Are Taxpayers Ultimately Responsible?

September 10, 2008
By Mukesh Chatter

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One of our recent blog comments asked my opinion on Credit Default Swaps (CDSs) in relation to the recent Freddie Mac (NYSE: FRE) and Fannie Mae (NYSE: FNM) takeover. I felt this issue merited its own blog entry.

First, a definition. From Investopedia:

Credit Default Swap (CDS): A swap designed to transfer the credit exposure of fixed income products between parties.

The buyer of a credit swap receives credit protection, whereas the seller of the swap guarantees the credit worthiness of the product. By doing this, the risk of default is transferred from the holder of the fixed income security to the seller of the swap.

For example, the buyer of a credit swap will be entitled to the par value of the bond by the seller of the swap, should the bond default in its coupon payments.

My personal take is that this situation is not as benign as it appears on the surface. While the takeover does benefit the mortgage holder, the real beneficiaries are hidden. Only about a dozen investment firms sell a large majority of CDSs, totaling around $62 Trillion dollars. If Fannie and Freddie's debt obligations were allowed to default, then these investment banking firms would be severely exposed, potentially making the firms responsible for an avalanche of payments. These payments could be worth hundreds of billions (or even trillions) of dollars for investment banking firms, such as Lehman Brothers Holdings Inc. (NYSE:LEH), JP Morgan Chase & Co (NYSE:JPM), Morgan Stanley (NYSE: MS), and Merrill Lynch & Co Inc (NYSE: MER).

The problem with this is: these investment banks don't have that kind of money - combine this with the cascading effect on hedge funds, not to mention the insurance companies covering the investment banking firms and the entire system could blow apart!

The tragedy of the situation emanates from the fact that one does not have to own the bonds in order to buy CDSs, resulting in an uncontrolled level of such derivatives, with no correspondingly sufficient reserves to support them. Yet because this situation is highly lucrative for investment banking firms it's allowed to continue. There is still no visibility or transparency regarding the amount of CDSs which have been underwritten by a a particular banking firm, or what the corresponding reserves against the CDSs are. The amounts are unknown, and lack visibility, permitting unconstrained CDS growth. One could make a parallel to the black holes people are fearful the Large Hadron Collider is going to create!

The consequence of this lack of regulation is that we're all left footing the bill for the CDS payment exposure, yet all the profit goes to the investment banking firms. In the end, it's the taxpayers - it's always the taxpayers - who are left to cover all the losses in the fall of Fannie Mae, Freddie Mac, Bear Stearns, and the rest - companies which would have gone under in a free market, but are being kept alive by these government interventions.

As if this wasn't enough, the top five banking firms doled out nearly $37 Billion in bonuses earlier in the year to their executives! I wonder if these bonuses were handed out to saddle us taxpayers with hundreds of billions of dollars in liability?

Is this fair? I would love to hear your thoughts on the matter.

Comments

On Sunday, January 18, 2009 Anonymous wrote:
Based on all that is happening, it is critical that middle class families split their goals between:

1. Paying off high interest credit cards.
2. Establishing the proper emergency fund to secure their family for the immediate long-term.

All of these things you are writing about are not only true....worse times could be coming. Developing a plan to save your family should now be your #1 goal.

Thank you for a great blog!

Loyd Ford
www.STICKYASSET.com/blog

On Thursday, September 11, 2008 Mukesh Chatter wrote:
@andrew: Increasing awareness of such a critical issue is the first step. Unfortunately, most of the media is focused on trivialities ("Lipstick on a Pig", for instance) instead.

It would be great if you could spread the word among your friends and ask them to pass it on, as well. Increased awareness of such an important issue should lead to some pressure on the powers that be.

On Thursday, September 11, 2008 Anonymous wrote:
Andrew, here's an interesting statistics. Since the takeover of Fannie and Freddie, mortgage rates has dropped by .4% on average. Apparently, because of the uncertainty surrounding Fannie and Freddie, it was costing more for them to sell their bonds. After the takeover, buyers of these bonds are willing to take on these risks for less. If Fannie and Freddie were to dissolve, what would the mortgage rates and therefore real estate industry look like?

On Thursday, September 11, 2008 Andrew wrote:
I have another question (or two). Some claim that if the government didn't step in, failure would lead to much more economic pain. How bad would it be? And wouldn't that be the good kind of pain, leading to people learning lessons?

On Thursday, September 11, 2008 Anonymous wrote:
Does the $10 trillion value assume that all debt would default, which is possible, but very unlikely. It's hard to know what the potential debt would be since it requires looking into the future. The hard part is the system feeds back to itself; more defaults engenders even more defaults because of higher rates and lower home values. However, barring an absolute meltdown of the financial system, I would think that the majority of loans will not default.

On Thursday, September 11, 2008 Anonymous wrote:
Thanks for the very enlightening explanation of CDS. It seems to me, an untrained eye, that CDS has lots of parallel to the insurance business. You're essentially insuring some asset by charging a premium to take on the risk for the potential loss/default of that asset. However, the insurance industry is heavily regulated, relatively stable, somewhat transparent (at least in regards to reserves and underwriting), and at the same time profitable. I think the CDS should follow the insurance industry example. There needs to be more regulation to ensure transparency and stability of this industry. They say that sunlight is the best disinfectant and I think this market is need of more transparency to clean out some of the excesses of earlier years.

On Wednesday, September 10, 2008 Colin Henderson wrote:
your assumption is somewhat correct. As soon as the Government takes over those companies, the debt becomes de fact government debt. This in fact doubles the US national debt in one fell swoop.

So the US Government now owes $10 trillion +/-. This is absolutely a problem inasmuch as it affects US inflation and currency value, etc etc.

On Wednesday, September 10, 2008 Andrew wrote:
Is there anything that we can do about it?

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