What the hell is a Credit Default Swap?

This American Life's hour-long show on "credit-default swaps" is the best explanation I've heard so far for what the hell these things are and how they ended up causing so much havoc. I keep asking economists, bankers, and finance people what this is all about and while I understood that somehow an exotic, unregulated, non-standardised financial instrument had created trillions in semi-illusory wealth, I just couldn't really understand exactly what that meant. This hour-long audio show does a great job of explaining the technicalities of CDSes, and then delves into their history, regulatory context, and problems, ranging from Congress to bankers to people on the street. Great stuff -- an hour well spent.

Another Frightening Show About the Economy (Thanks, Alan!)

• [grimc]

  “Wall Street’s Shadow Market” is a 60 Minutes piece that gives an easily digestable overview of CDSs, how they came to be and how they took down the financial markets.

  http://www.videosift.com/video/Wall-Streets-Shadow-Market

• [Blackmere]

  I second the Planet Money recommendation. The same people who put together that piece for This American Life and the first piece on the global financial system for them called Global Pool of Money (also a must hear) do this podcast. I recommend going back and listening to all of them.

  http://www.npr.org/blogs/money/

• [NJones]

  As someone who works in a financial house, I can tell you that this episode of “This American Life” gives an EXTREMELY misleading description of CDS. There are several very basic factual errors, which shows that these guys have absolutely no clue what they’re talking about.

  For example, I almost fell out of my chair when they said that the real problem in the CDS market is “netting.” They confused “netting” with “hedging,” which is roughly comparable to a mathematician confusing odd and even numbers. Netting is essentially a process of reducing the size of the CDS market by terminating redundant trades; hedging is (in the context of CDS) when one party to a CDS trade reduces his exposure to that trade by entering into an offsetting CDS with another counterparty. If you don’t understand that incredibly basic distinction, then you’re simply not qualified to talk about financial markets on the radio.

  The CDS market isn’t perfect, and the auto bailout could cause some problems for CDS written on the automakers, but it’s not even CLOSE to the biggest problem in financial markets. It’s been one of the few bright spots, actually.

• [stuckinkiel]

  @14 Zuzu

  I think it is very misleading to think of CDS as “just insurance”. An insurance company is required to possess considerable financial holdings before it can offer coverage. This was (is) not the case with CDS.

  Also, I would recommend listening to some EconTalk interviews about the federal reserve (as I posted in #4) for some insight into how little control the fed has on bank interest rates – I think you will be surprised, I certainly was.

• [Ugly Canuck]

  Casino gambling, this time on the outcome of other casino gambling, as if running a side table which takes bets as to who wins or loses at the roulette wheel, or on who is going to win the poker tournament. With a temporally variable payout, that is, you can cash out before the ball drops, or the Tournaments over.
  Might as well just “invest” in which raindrop gets to the bottom of the windowpane first, for all the good it does to those who need $$ to pay for their calories.
  It’s as if organized criminals had maxed out all other traditional ways of laundering their cash, or that it was taking too long, and in insufficient quantities, so they accelerated the action.
  Why did this activity go unregulated?
  Well, they have to grease the guys they gotta grease, like Marty said in the Long Goodbye.

• [Anonymous]

  let’s not forget about this insightful presentation I have found it thanks to Presentation Zen
  http://www.presentationzen.com/presentationzen/2008/10/collateralized-debt-obligations-cdos-are-investment-instruments-that-are-partially-to-blame-for-the-mortgage-crisis-what.html

• [zuzu]

  Credit Default Swaps (CDS) are just insurance that pays out equal to the balance (i.e. swaps) if a debtor can’t pay (i.e. defaults).

  All insurance assumes that failures will occur temporally in only a few market sectors at a time, and uses the premiums of everyone else to pay out.

  But when the monetary system gets distorted (e.g. through artificially cheap credit from the Fed), then every industry using that money (i.e. all of them) eventually experiences the adjustment difficulties simultaneously. When everyone fails at the same time, the insurance underwriters themselves default.

• [jacobian]

  @12

  Many insurance systems suffer from this local rather than global analysis of risk that you are describing. If you look at fire insurance you find much the same situation. The probability of a single house burning is not independent of the probability of a neighboring house burning in the same city (see california fires).

  Interestingly Henry Blodget points out another problem with local reasoning in reference to business risk.

  The banks currently are loath to loan to each other or others because in the current economic client they are likely to lose the money. If you have lots of banks each individually giving loans, this makes complete sense. However, if you want the economy to start functioning again, it’s insane since nobody is going to be able to maintain solvency without short term loans, leading to a deepening recession. A single monopoly bank would be able to give out loans and be in a much better situation since it would know that it wouldn’t be giving out loans to only a tiny fragment of the market. Global knowledge wins out.

  I think there has been entirely too little analysis of local versus global mechanisms in economics. Market fundamentalism and (well deserved) anti-government sentiment have kept people from exploring methods of ensuring accountability and performance of global systems.

• [jacobian]

  This talk is a really good introduction to CDS and other financial instruments and their relation to the crisis from a libertarian perspective:

  http://video.google.com/videoplay?docid=5166557324970205698&ei=AfVASd3JIZOQiQKh0vyqCQ&q=wsm+economic+crisis

• [zuzu]

  @13 Jacobian

  This is more like finding out that everything made of wood (houses included) is going to rot and collapse at the same time.

  However, if you want the economy to start functioning again, it’s insane since nobody is going to be able to maintain solvency without short term loans, leading to a deepening recession.

  What ever happened to savings?

  Oh, that’s right, Keynesian prescribed deficit spending (i.e. credit) killed it.

  Creating more credit to prop up existing bad credit is just “staying the course”. We need to “cut and run” from this fool’s errand before it destroys us all.

  The bust is a necessary correction for the malinvestment of the previous boom. The solution is to stop creating the booms by allowing banks to set a natural interest rate (based on supply and demand), rather than one mandated by monetary policy.

• [Anonymous]

  Michael Lewis, author of Liar’s Poker, explains credit default swaps, basically a bet that a securitized package of mortgages will go bad, in a ripsnorting article in Portfolio Magazine: http://www.portfolio.com/news-markets/national-news/portfolio/2008/11/11/The-End-of-Wall-Streets-Boom

  He even proposes a culprit who set the whole mess in motion.

• [skygzr]

  They call these things “products”. It sounds more like insiders gaming the system to create quick profits with as little immediate risk as possible.

  All this imaginary wealth is created and everything looks grand till the music stops playing. Just so long as the economy grows, right? As someone said, growth for the sake of growth is ideology of the cancer cell.

  Ah, greed. I probably would have done the same thing were I was able.

• [stuckinkiel]

  More ear candy about credit default swaps can be found on this Econtalk podcast:

  http://www.econtalk.org/archives/2008/11/kling_on_credit.html

  It’s a bit more academic, but still very accessible. I recommend the Econtalk podcast series highly. Even though I don’t always agree with the economics (or politics), I never fail to learn something new with each episode. It’s economics for the non-economist!

• [sabeke]

  For those who prefer reading about credit default swaps, here is a great article by Michael Lewis (author of Liar’s Poker and Moneyball):

  http://www.portfolio.com/news-markets/national-news/portfolio/2008/11/11/The-End-of-Wall-Streets-Boom

• [mmarlett]

  If you like this, you shoud check out these same guys’ now daily (about 20 min.) podcast called Planet Money. It’s my favorite.

• [CVR]

  I second that recommendation of the Michael Lewis article in Conde Naste Portfolio magazine. It’s as riviting as the two This American Life episodes (“Global Pool of Money” and “Another Scary Show About the Economy”).

  In normal times, financial journalism can be, for the “civilian”, boring at worst (pure numbers articles) to moderately exciting at best (good narrative features). In times like these, the best financial journalism is, to a nerd like me anyway, page-turning stuff, like a non-fiction equivalent to a great thriller novel.

  WaPo’s “The Evolution of Hank Paulson” features are pretty good stories (links below), and of course NPR’s “Planet Money” is trying to keep the flame lit by the “Global Pool of Money” TAL episode burning. “Marketplace” is also trying to get in on the action with “The Marketplace Whiteboard” videos and other similar reporting. It’s such an amazing story, only an election like the one we just had could eclipse it temporarily. Now, there’s not much else interesting to read about, at least for national/global stories.

  Part One:
  A Conversion in ‘This Storm’
  http://www.washingtonpost.com/wp-dyn/content/article/2008/11/17/AR2008111703787_pf.html

  Part Two:
  A Skeptical Outsider Becomes Bush’s ‘Wartime General’
  http://www.washingtonpost.com/wp-dyn/content/article/2008/11/18/AR2008111803938_pf.html

• [CVR]

  One more:

  “Why Wall Street Always Blows It” by Henry Blodget. He’s a surprisingly entertaining writer for a complete scoundrel!

  This article looks at why financiers can’t extricate themselves from bubble madness even though they see the writing all over the wall and know that there trades will soon wreak havoc on the markets.

  http://www.theatlantic.com/doc/200812/blodget-wall-street

• [Anonymous]

  @5 Amen! to NPR’s Planet Money podcast. It’s by the same guys who did the This American Life story. Also don’t miss the original This American Life episode, “Giant Pool of Money.” It’s about the sub-prime mortgage mess (remember that?) and is so entertaining that the local NPR affiliate in Seattle used it during a pledge drive.