Potential global economic black hole: credit default swaps (CDS)

January 17th, 2008

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It has been said that if you owe the bank one million dollars, you are in trouble. But if you owe the bank one hundred trillion dollars, the bank is in trouble. What happens if Tom owes you a lot of money and you are worried that he will default on his loan? Well, you can buy insurance to protect yourself against such event. Credit Default Swaps (CDS) is basically such insurance. It is a derivative in which the terms and conditions are privately negotiated between two parties. Thus, it is called an Over-The-Counter (OTC) derivative. How does it work?

Basically, you pay a periodic fee to a third-party. In return, that third-party will guarantee Tom’s loan to you in case he (Tom) defaults or partially fails to pay.

So, if all your loans are protected by CDS, you do not have to worry about bad debts right? Well, in theory, yes. But in reality, not really.

How do you know that the third-party guaranteeing your loan really has the ability to honour its contingent obligation? Since there is no
requirement for you to hold any of the third-party’s assets as collateral, its promise is as good as its credit-worthiness. So, it looks like you are back to square one again. Well, not really. This time, you’re paying money for a promise that is as good as someone else’s credit-worthiness.

Now, picture this scenario that we had described in Is this sub-prime or solvency crisis?

… much of the economic boom that we enjoy over the past several years are financed by the explosion of credit (which is debt on the opposite side of the balance sheet). There is such a colossal amount of debt created and scattered throughout the globe that it does not take a genius to see that massive amount of bad debts have to accumulate and build up in the global financial system. Eventually, all bad debts will be exposed as what they truly are.

Currently, the CDS market is valued at around $45 trillion, which is three times the GDP of the US. What happens if these waves of bad debts trigger the contingent obligations of CDS sellers to honour these mass of credit defaults? If these CDS sellers default themselves, what will happen to those who depend on CDS to remain solvent in the event of defaults?

We have a potential financial time bomb here. Note: we are not predicting that such a time bomb will explode. But this is another potential Black Swan, which Warren Buffets calls the “financial weapons of mass destruction.”