Credit Default Swaps ... OR ... How I Made a Killing!!

Guest Article by Michael P. Entis
First posted September 30, 2008

While visiting Toronto a few weeks ago, I discovered a well-aged package of Maple Leaf pastrami at a local supermarket. Suddenly, I was seized with a wonderful idea. Speculating that I might have come across a “perfect” sample of the product, I bought it and smuggled it back into the U.S.

A few days later, I had the chance to visit eFoodAlert. Sure enough, my sample of Maple Leaf Pastrami was staring back at me from the list of recalled production lots.

It was time to put my plan into action.

Amazingly, I was able to buy online a life insurance policy on my Connecticut aunt without her even knowing about it.

A few days later, I invited Auntie to visit. For her first lunch, I served cold cuts. She went home a couple of days later none the worse for wear.

The plan incubated beyond my expectations. Auntie was hospitalized seven days later with acute symptoms of listeriosis.

It was such a lovely well-attended funeral. I even wore my new double-breasted blazer for the occasion.

Immediately following my return home, I contacted the insurance company, presented them with a copy of Auntie’s death certificate and very shortly thereafter, I collected the $100,000 prize for my resourcefulness.

Okay, I lied!

Auntie is still alive and kicking in Connecticut. However, read the above story again. Replace “Auntie” with “Lehman Brothers 6% Senior Notes due 2010” and let’s give the insurance company a name ... AIG. You’re now reading about the life and death of a Credit Default Swap.

My latest issue of BusinessWeek magazine has an interesting article on the subject of Credit Default Swaps. While the article principally addresses the subject of Credit Default Swaps (“CDS”) in one’s mutual fund, what truly floored me were a couple of figures in the article.

But, before we get to that, let’s talk a little bit about why CDS exist at all. Let’s say that you’re running a mutual fund and you own those Lehman Brothers 6% Senior Notes. You read the Wall Street Journal and you watch CNBC on a regular basis. Lehman Brothers keeps getting into the news and it’s not altogether pleasant reading. So, while Lehman Brothers still enjoys an investment grade credit rating, you decide to protect that investment with insurance.

You contact AIG and tell them that you’re holding $10 million of Lehman Brothers 6% Notes due in 2010. You ask AIG to give you a quote on what it would cost to protect that $10 million investment in Lehman Brothers. AIG comes back to you a day later and says that it will cost you 1% of your $10 million Lehman Brothers investment each year for the insurance. This means that your rate of return on the Lehman investment will drop to 5%. But, it also means that you have protected your principal investment. If your mutual fund is a money market fund, you’ve just protected the fund from dropping below $1.00 per share. You say “yes” to AIG’s offer.

You now own a Credit Default Swap or CDS and you have protected your mutual fund investors with insurance from AIG, a highly rated (and now government owned) insurance company.

Now, back to those two figures in the BusinessWeek article. (Please don’t be intimidated by the word “trillion”. It’s simply a billion multiplied by 1,000.)

American corporations currently have about $6 trillion in outstanding debt. While that’s a humongous number by itself, I was totally blown away by the article’s statement that there is now $58 trillion of Credit Default Swaps outstanding. That’s almost ten times the amount of corporate debt outstanding. The holders of $52 trillion of Credit Default Swaps don’t even own any of the debt for which they have acquired insurance policies.

Why have they bought this insurance on debt that they don’t even own? Why are they so agreeable to paying for this insurance?

Here’s the clincher. These gamblers are betting that the corporate debt underlying the Credit Default Swaps that they own will go bad. It’s the same thing as my buying insurance on my Auntie (who I don’t own).

Now, we get to the really bad stuff. These gamblers, who bought Credit Default Swaps on debt investments that they don’t even own, have a powerful interest in seeing the debt-laden corporations go bad. Otherwise, they can't collect from the insurance companies on their investment in those “naked” Credit Default Swaps.

These gamblers, some of whom are unregulated hedge funds here in the United States, will do anything to drive those debt-laden corporations into bankruptcy, including the spreading of false rumors or simply making public statements which cause a debt-laden corporation to have to make public statements about how solid it is. Does this all sound familiar?

The United States Congress is currently squabbling over a $700 billion “rescue” of the American financial system. At the same time, we are encouraged to ignore the highly toxic fact that we have allowed the United States government to permit the growth of a $52 trillion unregulated hedge fund virus that is energized to destroy us in the name of greed.