Credit Default Swaps: What are they and why are they destroying us?

Credit Default Swaps, or CDS for short, are a type of derivative. Derivatives are financial instruments used to gain leverage over an underlying asset for a relatively smaller investment. Derivatives like futures, options and swaps were developed to allow investors to hedge risks in financial markets - in effect buy insurance against market movements - but have quickly become a means of investment in their own right. The “insurance” that CDS covers is the bonds that are traded for corporations.

In Warren Buffet’s 2003 annual report for shareholders Buffet made a loud and damning assessment of derivatives in general writing; that such highly complex financial instruments are time bombs and ‘financial weapons of mass destruction’ that could harm not only their buyers and sellers, but the whole economic system. It is widely rumored that CDS are largely responsible for bringing down AIG and Lehman, two companies whose balance sheets equal up to 15% of the entire US GDP for a year.

Let me try to explain in laymen’s terms why these derivative ‘insurance’ contracts are contributing to the destabilization of the entire world economy:

First off, let me explain the enormity of the issue. The CDS market’s estimated value is roughly $65 Trillion. Lets put this into perspective, this means that the CDS market is valued at over 4 times the entire US Gross Domestic Product (roughly $14 Trillion) and is EQUAL to the entire world’s GDP (roughly $65 Trillion). This means that the value of the CDS market is equal to about $9,285 for every man, woman, and child on planet earth.

Second, we will delve into why Buffet called them a ticking time bomb. I think just about every person understands the role of homeowners insurance so since CDS are really just an insurance vehicle (but for bonds) I will use homeowners insurance as my example. Lets say you bought a new $100,000 single family home. When you get insurance on it (as required by the lender) the insurance guy says “let me tell you what I can do, I will give you an insurance policy that will give you a $5,000,000 payoff if the home is damaged significantly if in exchange you pay me one large lump sum of $25,000”. In effect you have an insurance contract that leverages the value of the home many times over in case of significant damage. You say well since I’ll be living in the home for a long while it sounds like a great deal, so you take it. Now multiply this example millions of times, and then imagine a giant hurricane that completely destroys every home in Florida. Now, the insurance company that sold that insurance policy and all ready used that money for operations, stock dividends, and other issues has to come up with a HUGE amount of money to pay off this absurdly large promise on a grand scale for the entire home owning population of Florida. Obviously, the insurance company (in the CDS case it’s usually banks or large insurers like AIG) doesn’t have the money to pay out or even borrow the funds (especially in today’s credit climate) to pay off the obligation. And there we have it, immediate insolvency, default on an obligation and panic further spreading into the system. We are at zero hour now; hopefully somebody can make something happen so we can sleep easier at night, amen.