"Credit default swaps" for dummies

(NOTE FROM JOHN: Read this post. I remember my friend Ari trying to explain these things to me last winter. I gave him a blank stare. Now I get it. Fascinating stuff, and you'll actually understand it by the end of the post.)

Here is a post to demystify one of the least understood areas which contributed to our financial meltdown, and which needs reform NOW. I am talking about those “credit default swaps” -- CDS’s – which financial reporters never seem to be able to explain in terms anyone can understand. Maybe that is because they don’t understand them either, but the fact is that if people cant figure out what they are, then they will never get why to do anything about them. In reality, the basic idea isn’t all that complicated, and the need for reform is so glaringly obvious that there is no excuse whatever for delaying.

It helps to tell the story of why they were invented. Suppose you were the Chief Financial Officer of a corporation and you wanted to try to convince your management that it was OK to invest the company’s spare cash in some of those high yielding mortgage backed securities that everyone was selling just a couple of years ago. The corporate bosses would have been reluctant. Those mortgage backed securities were strange animals, with payouts based on the mortgage payments of thousands of bundled mortgages that underlie them. So in order for the company to get the very high interest rates that could be earned on these bonds, they had to believe that John and Jane Public would keep on sending the mortgage company their monthly payment for their McMansion.

“Too dangerous” they might say to the Chief Financial Officer. “What if these mortgage backed securities go bad? We can never go after thousands of individual homeowners to get the money. What insurance is there against such a loss?”

“Aha” says the CFO. “There is no insurance policy for these mortgage backed securities, but there IS a credit default swap market. We can pay a company (and not just insurance companies, any company could do it) to write a contract with us saying that if these bonds default they will pay us enough money to cover the loss.”

And that is what a credit default swap is. These “swaps” can be written to cover almost any kind of bond or eventuality – including the bankruptcy or buyout of an entire company. As long as few bonds are defaulting and companies aren’t going bankrupt (i.e., all the years until 2008) then it is a virtual money machine for companies writing the contracts. Since these aren’t even traded assets there was no capital requirement for companies to make sure they actually had the money to pay in the event of default. Since it was a private contract between two parties, and not an insurance policy marketed to everyone, there was no insurance regulation either.

Unfortunately, and as we all know now, LOTS of mortgage backed securities went into default at the same time when the housing market melted down. In fact, credit default swaps were at the heart of much of the financial market mayhem that taxpayers had to pay to fix over the past year. Regulators! You need to pay attention! Require some credit default loss reserves for companies writing these contracts! Then they will charge more for them and/or not write so many!

But the story is far worse than that. While not exactly corrupt in the strict sense of the word, some things are so corrupting or capable of creating such huge temptation to corruption that they simply shouldn’t be allowed. What if companies could buy credit default swaps to insure mortgage backed bonds or companies that they didn’t even own themselves? In other words, it was possible to get a credit default swap that would pay out if somebody else’s bond holdings defaulted or their company went bankrupt! So if somebody else’s company which you had no ownership in went bankrupt or got bought out then you could be paid a large sum of money.

Think about that. You could buy a contract which said that if some other company had trouble then YOU would be paid lots of money. The temptation for corporate raiders to buy the “insurance” and then try to force the default or bankruptcy would be too great for some of them to resist.

Here is an analogy which most people can easily understand. I have fire insurance on my house. The insurance company will pay me a huge amount of money if my house burns down. They are OK with this because they think I don’t really want the house to burn because I have my family and everything I own inside it.

But what if I could insure YOUR house? And what if I were a cold-blooded capitalist jerk who didn’t really care about YOUR family or YOUR belongings – my goal in life, my job in fact, was to simply make money? Why shouldn’t I run around outside your house playing with matches? Playing with matches may not be a good idea but it’s not actually illegal. What? You say your house burned down? Gee, let me check my insurance policies….

We need financial reform. The guys who were doing these kinds of things can’t be trusted. It is like giving children a box of blue tipped matches that will light on any surface. It is time for the grownups to step in and take away the toys.