Credit Default Swaps helped fuel market declines

One of the current residents in our market's house of pain is the almost unheard of before and little understood Credit Default Swap. I was ignorant of these vehicles and I consider myself up to date on the products du jour available to the investing public.

So what is this mysterious vehicle and how did it fast become the dominant vehicle in trading risk? To be blunt, just what is a Credit Default Swap?

A CDS is much like an insurance policy. After that, it gets pretty complicated so I am going to try and simplify for all of us.

Like any contract, there is a buyer and a seller. The buyer of the contract agrees to pay a fixed spread to the seller. In exchange, the seller agrees to buy a specified bond from the buyer at par in the event of a default. Most CDS contracts have a term or maturity date of five years, but other terms are available.

A CDS is supposed to be protection, like an insurance policy. The spread paid by the buyer is like the insurance premium. If there is a default, the buyer gets all their money back at par (dollar for dollar). It is kinda like having a homeowners policy on your house and you have a fire. The insurance policy pays you whatever your stuff was worth. Sounds OK so far, right?

CDS also are used for speculating on a credit. The buyer of the protection is essentially short the credit, while the seller is long. Selling or buying protection, may allow one to get closer to the credit with greater leverage. Further explanation gets pretty technical with LIBOR, arbitrage, facing counterparties and a host of other terms that most people never use in their everyday lives.

We have been hearing quite a bit recently about Credit Default Swaps with Warren Buffett calling them "financial weapons of mass destruction." But why did we hear nothing about them before? One of the first CDS deals came out of JP Morgan in 1997 when the firm hatched the idea of taking 300 of their loans and cutting them up into pieces (known as tranches). The bank then identified the riskiest 10 percent tranche and sold it to investors in what was called the Broad Index Securitized Trust Offering, or Bistro for short. This allowed JP Morgan to effectively rid themselves of the credit risk in the lowest tranche of the 300 loans by selling it to someone else. Soon, the whole world loved the idea of selling off risk to their neighbor. The CDS market went from nothing to more than doubling each year, surpassing the $100 billion mark in 2000. By 2004, CDS contracts totaled $6.4 trillion.

Then came the housing boom and the CDS market mushroomed like an atomic blast. Companies like AIG were not just insuring houses anymore, they were insuring mortgages too. The reason that the government came in with a bailout for AIG was because the insurer was the last backstop in the huge CDS market. It was banks and hedge funds that were playing both sides of the contracts thinking they were offsetting their losses, but AIG was holding the swaps.

It sounds to me like a game of musical chairs and the last one holding the bad loans, looses. All these shenanigans were going on unregulated and often off company balance sheets.

How was the investing public to know that these contracts existed and what risks they posed to their own portfolios? How will unwinding all these contracts play out when no one really knows the size of the market? These are but a couple of questions that come to mind that will have to be answered before the American public fully trusts Wall Street again. Some heads should definitely roll before this is over. Lets just make sure they are the right heads. Fingers are pointing everywhere.

Next time we will discuss what role the ratings agencies played on perpetrating what I consider a hoax on the investing public. Unfortunately, the house of pain has many roommates.

- Carol Perry, a Northern Nevada resident since 1983.