You want specifics? Sean DeCoursey forgot his password has even more specifics for you
Lifted from the comments to my post on the media's failure to explain what's at stake here, a most excellent explanation of the credit crisis by Sean DeCoursey forgot his password (hey, that's what he calls himself; I'm not gonna risk insulting him by just calling him Sean DeCoursey):
The simplest (and this is simplifying a lot) explanation:
Bob took out a mortgage for $1000 from Steve on which he agreed to pay back $2000 over the next 30 years. Steve split that $2000 into five packages of $400 and sold them to Jack for $300 each.* Jack has bough dozens of these little $400 packages. He combines 10 of them from 10 different people into a $4000 security that pays interest. Which he then sells to Jim for $3500.**
Jim says hey, I'm an institutional investor and I got a diversified security that pays steady returns over a 30 year term and is backed by real estate value. Yay me for safe investing! It's even rated AAA by the bond agencies.***
Unfortunately, Bob didn't get the big raise he was counting on at work. Now he can't afford the mortgage payment on his house. So he goes to Steve, his local banker, and asks for a renegotiation. Steve tells him that he can't because the loan has been split up among many buyers and sold several times and they're definitely not willing to renegotiate their fixed rate of return even if Bob can find them.
So Bob defaults on his mortgage, and Steve forecloses on Bob's house to recoup the loan. Unfortunately lots of houses are getting foreclosed and put on the market. Now Steve can't sell Bob's house for $1000. He can only sell it for $500.
Meanwhile, Jim hears about this on the news and realizes its happening all over the country. Jim realizes he has no idea how much, if any, of his securities are actually going to pay out. He tries to sell them to Ted the other institutional investor, but Ted is trying to sell his mortgage securities too.
No one is quite sure how much these securities are worth, but they definitely seem like they're worth less than what was paid for them, and the real estate backing them doesn't look so hot either. So everyone is trying to sell and no one is buying. The value just keeps dropping lower and lower, but still no buyers come.
Now Steve has some nice girl named Judy who wants to buy a house. And two fellows named Ben and Luke who want to start a business and go to college respectively. But Steve can't get any money from Jim or Jack because they're getting wiped out by the falling value of their securities.
Fortunately, Judy has an Uncle Sam who has a money printing machine and he wants to buy up a bunch of these securities so that their value will stabilize and people will start buying and selling them again. Then Steve can get the money to lend to Judy to buy her house, and Luke to go to college and Ben to start his business.
But Uncle Sam's wife, HoR, won't let Sam do it. HoR says that Jack and Jim are jerks who don't deserve to have any money because they don't work hard down at the tire plant like everyone else. And Bob is stupid for counting on that promotion so he shouldn't have taken out that loan in the first place. HoR forbids Sam from buying anything. So Judy doesn't get her house, Ben doesn't get his business, and Luke doesn't go to college. All because HoR wanted to get even with people for being jerks, even though really she just ended up punishing Judy and Ben and Luke who didn't do anything wrong at all.
Then there was a Great Depression and the Economy tanked and everyone lost their jobs. The end.
*Note that at this point, Steve has made a real and immediate profit of $500 and wants to lend out another mortgage right away.
**Jack has also make a $500 real and immediate profit on every "batch" of mortgage securities he sells. Jack wants to go buy more of these from Steve so he can keep buying and slicing and packaging them.
***Jim gets a bonus from his boss for doing so good and borrows money from Steve to buy a bigger house.
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1
Here are the numbers to back it up:
http://money.cnn.com/2008/09/30/magazines/fortune/varchaver_derivatives_short.fortune/index.htm
Riddle me this, Justin, how in the world does one regulate a market that is larger than the GNP of the world? Further, if something goes really wrong with CDS markets, what does that mean?
In a final comment, I am not surprised that no one in Congress has mentioned the $62T number. It is scary and would certainly cause panic and fear. Who has that kind of money? Or have the regulated markets been getting played by the unregulated derivatives?
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2
A (UK) Financial Times writer supported the bailout on the basis that at the moment the markets are dysfunctional - there are no buyers for assets legitimate or not. If the Fed can become the market maker for these assets banks are less likely to be downgraded, which currently seems to lead to instantaneous death.
Legitimate, well run institutions are falling over due to fire-sale prices. At some point this has to boil over to Main St. The trick will be to discern the legitimate assets & set a reasonable price. -
3
Bryan,
I trade interest-rate swaps, not CDS, and here is why the huge outstanding notional amount of IRS is not a problem:
1. The actual amounts exchanged are usually much smaller than the notional. For example, 50 million dollars of a plain vanilla 5 years semiannual swap involves 10 exchanges, each of the order of magnitude of $1 million net at most (and that's only if interest rates move a whole lot, say, 5%). More likely you'd see payments on the order of a several tens of thousands of dollar.
2. Swaps are generally not traded individually but in groups that offset each other. For example, I usually trade butterflies, where I'm long, say, a 5 year and short the 3 and 7 years. (The correct terminology would be receive 5 years and pay 3 and 7 years, but you could think of it as like being long or short bonds.) So the net exposure is only to the spread and the payments are much smaller. Moreover, as one position is increasing in value generally another is decreasing.
3. When you enter into a swaps contract you must place collateral with your counterparty if your counterparty has a better credit rating than you. Typically this is on the order of 1% of the notional.
4. Every day the position is marked to market and if it has lost money you must place even more margin with your counterparty, equal to the amount of the loss. If it has made money your counterparty must transfer margin to you. The minimum transfer amount is usually $10,000.So the exposure to a counterparty in case of default is usually not too large, if you are a broker or a bank. However, for hedge funds, which generally cannot get a 2-way margin agreement with a broker, there is more exposure to the fund. (The hedge fund places collateral with the broker when the position favors the broker, but not vice versa.) Thus the failure of a counterparty such as Lehman (who I used to face all the time), would be a bigger problem for a small client rather than a bank.
For CDS, on the other hand, I don't see how so much notional could be traded unless either actual payments are much, much smaller or the haircuts are tiny. (Haircut, in the swaps world, means the initial margin.) If the latter case then counterparty risk has been vastly underestimated, which is probably the case.
When we used to trade with Lehman, we didn't add an extra premium even though we often joked about their credit risk (and this was years ago); instead, we priced swaps with them off the same swaps curve as any other counterparty. Probably banks were doing that with CDS, too.
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