Understanding The Crisis, Part Four

This will deal with “Credit Default Flops“...I mean...“Swaps,” although "flops" might be a better term. You’ve undoubtedly heard this term on television news or read it in newspapers or magazines. This whole subject is VERY complex, and to be quite honest, I don’t understand all aspects of it, but I want to go through the basics, so that you understand what the term means, and what role they’ve played in the current crisis. What it really is, is insurance on various securities; that is, like bonds or mortgage backed securities, or loans, for example. The basic system is just like any other type of insurance. You have, say, some corporate bonds and you want to insure them. You get a “credit default swap” (aka “CDS”) on which you pay “premiums.” The insurer then agrees to pay you if the corporation fails to pay you; for instance, if it files bankruptcy, but it can be for just about any reason stipulated in the contract. This is easy to understand, right? Sure, but that’s “easy,” so far.

I’m not much for conspiracy theories, but I’ve got to admit, when you have insurance on something and you call it some far fetched name like a “Credit Default Swap,” it makes me wonder. The insurance industry is REGULATED. Credit Default Swaps are NOT regulated. Do you think perhaps the folks who devised “Credit Default Swaps” figured, “If we don’t call them insurance, maybe no one will notice?” Let’s face it, “Credit Default Swaps”....what the hell does that mean?^^^

Anyway, with no regulation, “Credit Default Swaps” became a big industry; so big, that “AIG” (American International Group)*** especially is in financial trouble, and U.S. taxpayers now own 80% of that company at least in part because of “Credit Default Swaps.” “Ah, do I see a hand? You have a question?”

“Randy, why is AIG in trouble because of “Credit Default Swaps?”

“I thought you’d never ask.” (I’m going to use “CDS” for “Credit Default Swap” for most of the rest of this article.)

Well as I said, the CDS business became big and AIG was THE biggie in that business. They insured anything and everything in the financial world. The thing was, they insured them for businesses or individuals who didn’t even OWN THEM!!! They also issued these “insurance policies” to many different companies and individuals on the SAME security!!! What does this mean?


In simple terms, they essentially bet that any failures on these various securities (bonds, loans, and “mortgage backed securities,” etc) would be small; after all, that’s the basic insurance business. Get a large pool of customers wanting insurance, and, if you get your calculations right, only a small percentage will need to collect on the policies, leaving the insurer with the rest of the money. For example, if an insurer collects a million dollars on a certain type of policy in a year, and only had to pay claims for a hundred thousand, they made $900,000.

The thing was, a CDS doesn’t need to be sold by an insurance company, or by any kind of certified agent. AIG had/has a financial services unit which marketed CDSs. Further, besides those who held some mortgage backed securities, for example, and wanted to play it safe by “insuring” these securities against default (non payment), those of “the investor class,” (aka “the sit on their ass class”)or others might want to buy a CDS in the expectation that a weak company might not be able to meet its obligations, and they too could get a payoff on a bond or other item they didn‘t even own. So, in other words:

You own some bonds in Company XYZ and get your “insurance” from a CDS transaction with AIG. You pay AIG premiums for the “insurance.“ I say, “Hmm, the issuer might not be able to meet the obligations on these bonds eventually.” (And here you thought "gambling" was only legal in certain places!) I too take a CDS on the same bonds and pay AIG premiums. Company XYZ hits a rough business cycle and can’t pay on the bonds. AIG now has to pay BOTH you and I.

From what I’m understanding, many in the CDS business thought they’d struck gold, as they were collecting premiums from all sorts of people, often on the same bonds or other security, especially in more recent times on “mortgage backed securities,” which were securities backed by American mortgages. They felt that the chance of having to pay out much was very low risk (Hey, they were backed by AMERICAN mortgages), and so they didn’t keep enough money on hand to pay potential claims. In the REGULATED insurance business, an insurance company has to keep a certain percentage of possible payouts in reserve to be able to meet obligations should the need arise. When the mortgage business began to collapse, the “mortgage backed securities” lost value and payments on these securities were missed. Now the companies that had all of these “swaps” out had to pay off. In the case of AIG, they suffered huge losses and the actual money making parts of their business had to help cover the losses in their financial business, which still wasn’t enough....enter the U.S. taxpayer. The feelings among many in government and the Federal Reserve has been that with AIG not only being a big player in the American financial and insurance markets, but also with large holdings overseas, if they collapsed, that it could cause a world panic. So, we have another business that’s “too big to fail.”


A side note: In the Fall of 2000, Senator Phil Gramm (R-TX) and Senator Richard Lugar (R-IN) sponsored a bill that barred most regulation of credit default swaps. Democrats weren't innocent, and many supported the bill, as did some in the Clinton Admiinistration, which was about to leave office, and it had especially strong support from "The Deregulation King," Fed Chairman Alan Greenspan.

To be continued... And if I learn more details about Credit Default Swaps that seems appropriate, I'll do another article.

^^^Actually it means this: if you buy a bond, for example, you now are at risk to lose your money if the bond issuer doesn’t pay you. By getting “insurance” for the bond, the risk has now been traded (swapped) to the insurer. They have to pay you if the bond issuer doesn’t pay.

***AIG is a huge international corporation that also sells “traditional” insurance, like life insurance, and consists of a number of component companies, including outlets overseas.

Word History
Credit-Believe it or not, this word only came into use in English during the 1500s, although some of its relatives came to English somewhat earlier. It goes back to Latin "credere," which meant "to trust, or entrust, or believe," whose participle form gave Latin "creditum," which meant "something entrusted to another person, a loan." This was passed on to Italian as "credito," and then onto French as "credit," and then onto English.