Friday, October 31, 2008

Credit Default Swaps: Recent Stories from NPR

National Public Radio

In a
previous post I mentioned, without much explanation, that credit default swaps (CDS) were instrumental in creating the 2008 credit crisis. As it happens, Alex Blumberg has done some of the clearest reporting on CDS for a National Public Radio (NPR) program, "This American Life."

Credit default swaps, which have become featured players in the troubled asset drama, are over-the-counter contracts that have been widely used to hedge investors against the risk of mortgage-backed securities. Unlike insurance policies, however, they do not require that either party actually own the assets being protected. As one of their inventors, Gregg Berman, explains:

It is exactly like buying insurance for a house you don't own.

And that is the very definition of moral hazard. Speculators can enter the market to bet against houses they consider at risk, thereby creating a market for arson. And bet they did.
Berman and Satyajit Das, a risk consultant, were interviewed for the story, How Credit Default Swaps Spread Financial Rot.
Das says that during his time in the industry, the amount of credit default swaps that were speculative grew to dwarf the amount that were used for insurance...There are $5 trillion worth of bonds issued in the world, but the total amount that people have bet on those bonds is $60 trillion.
Because they were traded over-the-counter, CDS have been unregulated and are nearly invisible to investors. We now know that many of the obligations to cover mortgage-backed securities are held by AIG, an insurance firm. On 16-Sept-08 the U.S. Treasury seized control of AIG and has now invested about $122 billion to prop it up.

This week I received a letter from AIG offering me an Essential Health insurance plan. The envelope exclaimed:
You Can help get greater control of your medical expenses. (And for less than you think.)
Imagine my excitement as I raced to read the fine print.

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