Financial Weapons of Mass Destruction - Credit Default Swaps

While Bush was busy searching for weapons of mass destruction in Iraq, he neglected to bother about the ones that were being "stockpiled" in his own country. No we are not talking about warheads, but Credit Default Swaps - or "Financial Weapons of Mass Destruction" as Warren Buffet, the most successful investor in the world, likes to call them. Now that they blew up in America's face, leaving the country in recession, and spreading the fallout across the world, we will try to see what these things were about.

So what exactly are these credit default swaps? Lets say Bank X loans a large sum to a lets say Tom for mortgage. There is a chance that Tom might not be able to repay his mortgage. In that case, the bank stands to lose the money loaned - which is a major risk for it. So to offset the risk the bank enters into a Credit Default Swap contract with a counter party. Bank X then starts paying fixed payments to the counterparty. In turn, the counterparty assumes all risk of the person defaulting on the loan itself. Although this looks like a typical exchange, the rotten part of it is simply that - the seller of the contract does not need to have any real assets to make the contract.. and can technically go bankrupt.

So a credit default swap makes everyone happy - as long as Tom is making his payments. For Bank X, it kept a huge amount of default risk off its books, and for the counterparty, it is pure money for nothing. But once Tom does not pay his mortgage payment, as it happened, then the system begins to unravel... Bank X demands money from the counterparty, who might go bankrupt since he does not have enough assets to make good his promise. The counterparty is also unable to raise the cash, as the house value would have fallen in the market. So it declares bankruptcy. Immediately, the huge losses starts to appear on the books of Bank X... which takes everyone by surprise, since it was not "expected".

The market for Credit Default Swaps is Over-The-Counter, and not regulated well. In some instances big firms used to buy CDS contracts from little known players, who declared bankruptcy once the defaults started piling up, forcing many big firms to become insolvent. The notional value of the CDS market grew from a couple of hundred billion dollars at the end of 2000 into more than $40 trillion by 2005.

This is one of the reasons for the US Govt trying to bailout firms. Since if they have lots of CDS contracts, then shutting them down would force some other company to take huge debts onto its books immediately, and itself become insolvent, starting a chain reaction. The govt hopes that this will in the meantime allow the values of the assets to grow slowly, and reduce the impact on the firms.