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Tuesday, October 7, 2008

Credit Default Swaps: $60 Trillion of Bullshit

posted by on October 7 at 15:30 PM

Car insurance makes sense. If I drive or own a car, I better have some way to pay for repairs and healthcare if I fuck up.

And it makes sense that the insurance company better be tightly regulated—forced to keep enough liquid assets around to pay out claims. If the insurance company failed to pay up, it would be a nightmare for everyone.

Credit Default Swaps (CDS) started out as insurance for bonds. For a percent or two a year of the face value of the bond, you received a contract to pay the face value of a bond if the issuing company defaults. This is little different than life insurance, homeowners insurance or car insurance.

The trouble started in 2000, when the Commodity Futures Modernization Act explicitly banned the regulation of these sorts of contracts. Funny things started to happen; people took out CDS contracts on bonds they didn’t hold.

This would be like me insuring your car. Why on earth would I do that? It’s a bet. If you get in an accident, I get paid; I’m gambling on your failure.

I could be even more clever, and eliminate my risk entirely—at least on paper.

Let’s say the government similarly prevented regulation of the car insurance industry. I have $2000 I want to invest. Your car is worth $20,000.

Now you’ve been a good driver so far, but I know you’re starting to drink more. A DUI would force you to pay much more for insurance. But, for now, you are cheap to insure, so I buy a long-term ten-year contract insuring your car at $20,000 for 1% a year or $200. I wait, paying the $200 premium out of my $2000 in starting cash.

The DUI happens. Huzzah! Now, you’re desperate for insurance, and thus willing to pay much more! Four percent a year, baby! I quickly sell you a contract, paying you $20,000 if you get in an accident that forces you to pay me a whopping $800 a year.

I still have to pay out $200 a year for the contract that will pay me, but I’m getting $800 from you. I net out $600 a year, or 30% of what I started out with. Best of all, it’s risk free for me! If you get into an accident, I can pay you the $20,000 from the money I’ll get from my earlier contract, right?

Well, not exactly. What if the guy who sold me that earlier $20,000 policy is also doing the same gambit, also leveraging a tiny bit of liquidity he has into a huge contract? And the person he bought a contract from is also doing the same game? And the person after? Horrible cycles can develop, where nobody in the chain really has the money needed to pay off the stack of contracts.

Everything would be fine, so long as you didn’t into an accident. If you did, it’s going to take a while for the deeply nested and intertwined, hedged contracts to undo themselves. You’d be left with a crashed car, and no sense that you’d get anything back for all those premiums you paid. I’d be left holding $18,000 in net debt that could be totally paid off (if the contract I hold is good), or all mine to eat (if it’s bad.) All it takes to make these contracts all bad is one irresponsible bettor at the bottom, who didn’t bother hedging his promise to pay with a CDS of his own, and doesn’t have the money to pay his promise.

This is precisely why the insurance market is tightly regulated. Since the credit default swap market wasn’t, this sort of tangled mess grew into existence.

Well, how much money is tangled up in these sorts of “investments,” that did nothing of value, started no new companies, produced no new knowledge or techniques and are glorified get-rich-quick schemes worthy of a shitty sitcom episode?

Sixty trillion dollars.

So many huge numbers have been thrown around in the past few weeks, this might be hard to grasp. In perspective, the entire economic output of the planet was less than $60 trillion in 2007, at about $55 trillion.

2007 was no ordinary year; 2007 was the absolute peak of human endeavor, so far. More human beings were pressed into economic service, in a more integrated global economy than ever before. Every single planetary resource was tapped at the maximum, every input stretched to the highest ever limits. 2007 was the very best that human effort has ever accomplished. $55 trillion dollars of economic might is an astonishing amount of stuff, about $8000 worth for every human being on the planet. Real stuff. Not paper promises. Not a line on an electronic spreadsheet, or a number in a database. $8000 worth of actual services and products per living person on the planet—surgeries, dental work, televisions, telephones, power lines, meals, airplanes and flights between cities, homes and all of the other real tangible and non-tangible things that make our lives, that sustain us and allow us to experience our world.

It might be impossible for our government, even the entire collective force of governments worldwide, to untangle this mess of a fake parallel $60 trillion dollars, no matter how much tax money is thrown at it. The entire bailout so far—already unprecedented in scale and aggressiveness—has amounted to something around one trillion of hard earned real world dollars—a drop in a bathtub of woe.

We can’t untangle this mess because it was all bullshit to start off with. These sorts of cyclical, leveraged schemes aren’t investing in any true sense of the word. This wasn’t even gambling. It was a means of making numbers in spreadsheet go reliably upwards—increasingly detached from the real world, where making things grow and get better takes effort and risk.

We cannot fix a world of make believe. Yet this world of make believe threatens to throw our efforts in real world into a tailspin, our desperate fifty-five trillion dollar struggle to feed those who are hungry and unfed, to clothe those who are cold, to house those who are homeless.

The illusion of risk-free, effortless gain is unraveling for those pampered and detached enough to believe such crap could be true. So much of the growth of the past few decades has been concentrated in this bullshit, these lies we’ve told ourselves while neglecting the real investments that could’ve made such gains a reality. It’s done.

We cannot resurrect that $60 trillion bullshit dollars tied up in bullshit CDS contracts without making our real $55 trillion dollar world go through a spasm of painful hyperinflation. In a world of $40 gallons of milk, $100 lunches on the Ave and $10,000 a month rents, we probably could conjure the illusory $60 trillion dollars into real existence.

Why should we?

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Methinks someone listened to This American Life this week.

Posted by boyd main | October 7, 2008 3:40 PM

This stuff confuses and frightens me. I think there's even more dangers though than simply "big", "leveraged", and interconnected.

We have a court system designed to resolve bankruptcy. It's extremely complicated and courts have to make judgement calls about fairness and intent.

Now you've got third parties with bets riding on the resolution of negotiations in which they have no standing.

If you're trying to insure me you'd better be sure that you have exactly the same requirements and procedures as the person you think you've sold the problem to.

Posted by daniel | October 7, 2008 3:48 PM

Yeah, that's a problem.

This market needs to be regulated NOW, not just to control the trade but to make it transparent, see who's holding what.

Posted by Fnarf | October 7, 2008 3:50 PM

Oo, I listened to it too. I loved the wrapup bit about CDS where the nice expert fella pointed out that thanks to zero regulation and zero reporting requirements, nobody has more than a vague idea how much may be tied up in that unraveling market. So $60 billion is more of an algebraic inference, really.

Posted by tomasyalba | October 7, 2008 3:53 PM

oops - for "billion" substitute "kajillion." dang liquid lunch again.

Posted by tomasyalba | October 7, 2008 3:54 PM

In principal it's not a problem. In fact it's not that crazy. A hedge is a hedge, gambling is gambling, and CDS's can serve as useful hedges.
To use your analogy it WOULD make sense for me to insure your car IF your getting in a wreck infecte my income. Say you were an employee of mine and I could get the insurance really cheap. Of course that wouldn't help you, but if you were to get in a wreck and my income suffered, then I'd have the insurance payment as a hedge against that eventuality.
It's not the instrument itself, but a lack of regulation in how it was used that was and continues to be the problem.

Posted by kinaidos | October 7, 2008 3:59 PM

Do we allow life insurance policies on random people?

The biggest problem with CDS is that they aren't backed by anything other than the credit confidence of the counter party risk.

Posted by Bellevue Ave | October 7, 2008 4:04 PM

@6: I don't remember the specifics atm, but didn't Wal*Mart get in trouble for taking out life insurance policies on their employees?

Posted by A | October 7, 2008 4:11 PM

Also, anyone remember that Beavis and Butthead episode where they have to sell candy bars? They are each given a box of candy bars to sell for fundraising. They each sell one for a dollar to the first house they go to. Then, Beavis "borrows" a dollar from Butthead, so he has two dollars. He buys a candy bar from Butthead with that two dollars. Then Butthead buys a candy bar from Beavis with that two dollars. Back and forth until all the candy bars are gone. Then when they go to turn in the money, Butthead asks for the dollar back that he lent Beavis. The fundraiser guy was PISSED! Then when they realized that since Beavis and Butthead fucked up and there was not enough money for the class trip, everyone got their parents to pitch in to bail out the class trip fund.

Posted by A | October 7, 2008 4:21 PM

This is like the reinsurance spiral that happened in england back in the 80s. The companies kept poor track of their retrocessional reinsurance and were in effect passing a hot potato around all the way around a circle back themselves.

Posted by Bellevue Ave | October 7, 2008 4:22 PM
Posted by A | October 7, 2008 4:24 PM

A @ 9: Thank you! I was trying to remember this reference. Updated the post.

Posted by Jonathan Golob | October 7, 2008 4:25 PM

Bet you're sorry now you didn't buy my credit default swap default swaps - insuring against exactly this kind of train wreck - when they were cheap (because everybody thought the trains would run on time forever) ... but you can still buy in for just a few trillion dollars.

Seriously, it's not a $60T problem - because most of the unsettled obligations offset each other.

If the buy sides and sell sides of this insurance game were neatly chained together, we could settle one chain at a time (by spreading the uncovered liability over the chain, from end risk-dumper to end risk-taker). All of the players would get hurt in the process, and some of them ruined, touching off additional defaults.

Unfortunately it's not that simple, since ultimate risk-bearing responsibility wasn't simply passed down the line on a 1-to-1-to-1-to-1 basis ... all this was done in something closer to the most complex conceivable fashion ... but it's still nothing that requires $60T or a million monkeys at a million keyboards for a million years to unwind.

Posted by RonK, Seattle | October 7, 2008 4:35 PM

Anybody who listened to This American Life on Saturday had a very bad weekend. As I said before, WELCOME TO GD2. The problem, which NO ONE CAN FIX is linked-leverage. All of this crap has been bought and sold on credit. So it only takes one default to set off a chain reaction. It's endemic and the only way to clean it up is to let someone give us 60 Trillion (and counting) or default on the debt. That's right, Mass Default. Sort of like Mass Extinction, except this time it's your retirement accounts, your job and maybe the country that's being wiped out. Sound scary? Good.

Posted by crazycatguy | October 7, 2008 4:43 PM

#9 - reading about the credit crunch I've been thinking about that episode as well. It's one of my favorites just behind "Best Day Ever".

Posted by Dougsf | October 7, 2008 4:49 PM

@ 6 -- Hedges can be problematic, even if they all clear.

Take the case of tournament sports - golf, tennis, what have you. It's common practice for players to bet a little against themselves going into the money round, so they cash in enough of their results to cover travel expenses whether or not they pass the next hurdle. No problem there.

The very same hedge bet, multiplied by a small constant, can be used to give the player an undisclosed motive to dump the game and lose at the critical juncture (which is apparently suspected in the case of some Masters of the Universe today).

The more serious practical vice is the use of derivatives (stock options being a simple case, and the Wall Street annual bonus compensation system being even simpler) to give executives positive exposure to corporate gains from their risk-taking decisions but zero exposure to corporate losses ... biasing their behavior toward the idiotic.

Posted by RonK, Seattle | October 7, 2008 4:50 PM

@15: Yeah, but it's unrealistic. In real life they would be FORCED to pay back the money, or face consequences since they did eat the candy bars. Oh...

Posted by A | October 7, 2008 4:53 PM

I forgot how much I love that show.

"Blah blah credit blah blah markets blah blah. . ."

Posted by violet_dagrinder | October 7, 2008 5:12 PM

Bill Clinton must have forgotten to veto that bill. Cause Democrats don't favor deregulation, do they?...

Posted by Trevor | October 8, 2008 7:01 AM

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