Monthly Archives January 2009

Insuring Debt is Stupid

With talk of £300BN being used to insure banks bad debts it rang alarm bells because it’s one of the prime factors that has seen Western economies fall to their knees.

Do you know what a ‘Credit Default Swap’ (CDS) is?

It’s a bit like an insurance policy to protect against defaults on debts. But it’s not really insurance it’s just an agreement to pay a regular amount in return for a lump sum if a default occurs.

Payment protection has been around for a long time as a consumer product which will protect a borrower if they lose their job or can’t work due to sickness, disability etc. It’s also an extra cost on top of the borrowing so needless to say, people with limited budgets probably wont buy it.

But thanks to CDS’s it’s possible for a third party to ‘protect’ a debt.

Wikipedia says it well but in basic terms, Company A can ‘protect’ the debts of Company B even if there is no association between the two companies.

It’s a bit like betting on whether or not a company will default on its debt obligations. If it does, Company A will be entitled to a payout. If it doesn’t, Company A will have paid ‘premiums’ and received nothing in return apart from possibly some peace of mind.

“By the end of 2007, the CDS market had a notional value of $45 trillion”

Yes, that’s $45 TRILLION.

The US Gross Domestic Product was only worth $13 trillion in 2007.

OK, so not all of the debts associated with CDS’s will default but some of them have, namely ones tied up with the US adverse mortgage market.

I read somewhere as many as 1 in 10 US mortgages are likely to default between now and 2010. There are currently approximately 70,000,000 US homeowners.

I’m not sure of the specifics but a default doesn’t always lead to foreclosure but will a CDS contract pay on default as opposed to foreclosure?

If it does, that’s nearly 7,000,000 US homeowner who may default.

Once again I don’t know the details but if a CDS pays the full amount of the debt and the average house price in the US is $280,000 (courtesy of economagic.com) then we’re talking:

$280,000 x 7,000,000 = $1,960,000,000,000 nearly 2 trillion dollars.

And that’s just the mortgage defaults. In this current climate business are also defaulting on their obligations.

So to suggest insuring bad or toxic debt in a climate which is bound to see more defaults the Government must be mad!

Lenders assess the risk and price their loans accordingly. It’s their risk and they factor it into the calculations for maintaining their capital adequacy. If people default, the lenders suffer and so they should because it’s THEIR RISK!

OK, so regulators have a lot to answer to as well but clever banking minds should have been able to see the increased risks caused by deregulation of the past?

But allowing other people to ‘play’ the market and gamble (with other people’s money in many instances) and then allowing that trading to become worth over 3x the US annual GDP…. Without regulation…. Someone, somewhere (who is probably very rich by now) should have trouble sleeping at night.

I admit, I’m by no means an expert on any of this. I have been reading and researching in my spare time but even I can sense that there is still more trouble ahead….