The problem concerns Credit Default Swaps also known as CDSs. Now, before you lose interest and click on to the next thing, please bear with me for just a bit longer because this will interest you. I guarantee it, trust me, I’m a banker.
Despite their technical and serious sounding name, in principal, the purpose of a CDS is rather simple. The idea is that you can buy insurance against a default. It works like this:
You own a bond, let’s say it’s a Greek government bond. Understandably you are worried that Greece will not make good on their debt due to a little bit of a cash flow issue. Therefore you buy a CDS contract that pays out to you in case Stavros and his mates won’t be able to pay up. This way you have protected your investment. (People in finance like to call this type of protection a hedge).
Well nope. Unfortunately it has the possibility of going pear shaped.
Let's look at an example:
According to the New York Times Radio Shack’s total debt came to $1.4 billion but swaps outstanding on its debt were $ 23.5 billion. Think about that for a moment, because it wasn’t a typo. $1.4 billion in total debt, with contracts insuring against default standing at $23.5 billion. That’s 17 times more!
What does this mean? It means that the CDS market isn’t about insuring against default, it’s about gambling like Las Vegas, just without the strippers and Blackjack tables. Those dealing in CDSs are taking a gambler's punt on Radio Shack, nothing more, nothing less.
The problem here is that there are tens of billions betting on Radio Shack either going bust or not. This money has nothing to do with the actual business viability of the company. We are in a tail wagging the dog scenario where it is in the interest of certain parties for Radio Shack to default even if Radio Shack is in a solvent position and able to pay its debts.
Compounding this problem is that CDSs are an over the counter (OTC) product. What this means is that they are not traded on a transparent exchange. They are created by banks and bought and sold by speculators/investors/traders, call them what you like, and there is very little transparency on the size of the positions held by these entities.
With tens of billions on the line, you should by now see the possibility and the strong temptation for manipulation and corruption to bring about a default scenario.
This is a serious problem that doesn’t just concern one firm, CDS contracts are all over the place and with the current several year long bull market in bonds, one can only imagine the size of the CDS mountain behind all the outstanding debt.
When it goes pop. You're going to hear it.
Tomorrow I’ll come back to this subject and dive a little deeper into CDS contracts.