Credit Default Swap Problems

Submitted by Rich Toscano on January 18, 2008 - 8:19pm

Back in November 2006, I wrote a long-ish piece about credit default swaps. These financial instruments, known for short as CDSs, basically function as insurance policies against borrowers defaulting on loans. In (very) brief, the premise of the article was that some CDS issuers, which we can think of as insurers, probably didn't have enough money to cover the losses once homeowners started defaulting en masse. Once this came to light, I wrote at the time, it could cause a tightening of credit for San Diego's leverage-happy homebuying public.

I never really followed up because the credit tightening ended up being triggered by problems with a different type of credit derivative, the collateralized debt obligation.

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Submitted by bubba99 on January 19, 2008 - 7:25pm.

Although the credit crunch began with CDOs tied to crappy assets (mortgages) I believe that CDSs could create a greater wave of financial uncertainty. Few people understand CDSs - how they are priced, chained, valued, or even how much is out there. A few strategic defaults could wipe out trillions in capital.

A CDO failure may trigger a counterparty failure, which triggers a fire sale on CDOs and the cycle repeats through hundreds of counterparties. As the insurers (counterparties) fail, the underlying security may need to be downgraded - which triggers more CDS payments. The only thing that may prevent a disaster is the complexity of nested CDSs, and the fact that even knowledgeable financial people do not understand how CDSs were bought and sold in the last 6 years. A panic may be avoided because the chains will be so complex to unravel that it could take years for all the dominos to fall.

Submitted by NateK on January 21, 2008 - 3:20pm.

What happens to SRS(2X inverse Real Estate ETF) which seeks it's investment goals through Credit Default Swaps? It looks like the counterparty risk is something to really keep an eye on. Anyone else have thoughts on how far to hold SRS.

Submitted by JerseyGrl on January 22, 2008 - 8:20am.


Thanks, I appreciate everyone's thoughts on this subject.


Submitted by barnaby33 on January 28, 2008 - 4:21pm.

CDS are a zero sum game. That is for every winner, there is a loser. the real risk is that of counterparty failure. People talk about the 500 trillion in CDS. Whats important is what they are insuring against. Theoretically if all of those CDS's are written against one pool of mortgages, the maximum real loss is the pool of mortgages plus premiums paid for the insurance. Thats why nobody knows where the sausage is being hidden. Nobody really knows whats insured by whom and how much capital they have to accept the counterparty risk.

When these start unwinding all sorts of businesses that you didn't suspect were playing the leverage game will get caught out and fold. The monoline bond insurers are just the most obvious.


Submitted by cmonterroza on March 1, 2008 - 1:13am.

I think you got yourself a goldmine there. I wrote an article on my blog about Julian Robertson a couple of weeks ago where he explains his CDS strategy. He expects to make 20x his money on the things betting against subprime.

Here's the article:

It's a link to the Wall Street article.

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