Money Credit Default Swaps: $60 Trillion of Bullshit
posted by October 7 at 15:30 PMon
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?