A couple of years ago I took an interesting course called “Credit Risk Management” where we learned how to calculate some of the more arcane derivatives such as interest rate caps, floors, and swaps, and credit default swaps. It's an extremely fascinating science in risk mitigation.
Credit default swaps (CDS) are a risk mitigation technique. A CDS is an insurance policy against bankruptcy. More specifically, an entity enters into a CDS contract to insure against another entity’s debt (credit) becoming worthless. To calculate a CDS, you must know the entity’s probability of failure and probability of survival for each period of the CDS contract. Throw in t-bill yield curves, future rates, spot rates, discount functions, and you can begin to calculate the basis point spread (margin) between what the debt (bond) is currently trading for, and what you think it “should” trade for given its bankruptcy risk.
A scary document from the ISDA (here)
According to International Swaps and Derivatives Association, the notional value (essentially, the face value or underlying value) of CDSs was $62.2 trillion and growing rapidly. Said another way, if all the companies listed on the stock market went bankrupt tomorrow, someone (like AIG, or now the American people) would have to pay out $62.2 trillion dollars even though the entire worldwide stock market is valued at between $20 and $30 trillion. By comparison, the mortgage market – which has caused the greatest economic crisis since the Great Depression – is a mere $7 trillion and falling. (Source). Another scary number on that ISDA document: $382 trillion – the notional value (the underlying value at risk) of all interest rate derivatives outstanding. On their most basic level, think of an interest rate derivative as the transaction you went through to fix your variable mortgage or student loan. On a whole the derivatives market is around $450 trillion dollars (or 12 times larger than all the economies on earth put together).
So what happens when that $450 trillion starts sloshing around? What happens when an interest rate lowers or raises higher than expected, or when mortgage backed securities go belly-up, or when major companies begin to go bankrupt? I can’t think of anything less than economic catastrophe. We're already seeing companies that pay out CDSs beginning to go bankrupt, and the SEC declared no short selling financial stocks to keep other companies that pay off CDSs from going bankrupt like AIG. AIG was the largest backer of CDSs. Check out an article from February of this year (here). Then follow that up with an article from last week (here). People spoke about AIG’s exposure to CDSs earlier this year, and sure enough, AIG went bankrupt this month.
I encourage others to read more about CDSs, about AIG, and about the dollars associated with these derivatives. It makes you quickly realize that President Bush’s $700 billion is 1) directed precisely at the derivatives market, and 2) grossly and incomprehensibly under funded. $700 billion is 1/645th of $450 trillion. Now I realize what Bush, Bernanke, and Paulson mean when they say: “There is a much greater risk to doing nothing.”