Freddie Krueger’s CDS

Fredkruegermoviefirst

Elm Street’s Freddie Krueger

A Credit Default Swap is a very simple financial instrument. But, when I go over its wiki definition I can’t avoid thinking that Freddie Krueger must’ve been involved in the creation of this nightmarish contraption:

A credit default swap (CDS) is a contract in which a
buyer pays a series of payments to a seller, and in exchange receives
the right to a payoff if a credit instrument goes into default or on the occurence of a specified credit event
(such as bankruptcy or restructuring). The associated instrument does
not need to be associated with the buyer or the seller of this contract.[1]

In other words, there is no requirement on the seller to guarantee and provision his side of the contract in case of a default. I repeat, no requirement, as in nada or none.

 

So, I can perfectly understand why it spread like wild fire. It was
easy for any cold blooded crawling creature to sell CDSs and collect a
fat premium, without ever being asked a question about how in the hell
was he going to meet his obligations on a debt default.

Cds

According to this excellent article from Fortune Magazine, CDS grew to top $62 trillion by the end of 2007, and is at a $55 trillion level as of june.

Not only is its size troubling, but, no one knows how far into the economic weaving is this instrument intertwined:

"The big problem is that here are all these public companies – banks
and corporations – and no one really knows what exposure they’ve got
from the CDS contracts," says Frank Partnoy, a law professor at the
University of San Diego and former Morgan Stanley derivatives salesman
who has been writing about the dangers of CDS and their ilk for a
decade. "The really scary part is that we don’t have a clue." Chris
Wolf, a co-manager of Cogo Wolf, a hedge fund of funds, compares them
to one of the great mysteries of astrophysics: "This has become
essentially the dark matter of the financial universe."

I understand the Fed started talks with ICE and CME to bring into one of these exchanges the CDS transactions, which would undoubtedly help their liquidity.

The Fed also plans to auction the Lehman CDS shortly, on October 10, whose outcome is said to have all banks on their toes, because it will start the discovery of the market price of CDS. Once this is achieved, the Fed will have the tool to be able to determine which banks may be helped because they are troubled but solvent, and which are insolvent and must go. And, as a consequence banks will resume lending to each other, knowing that their loans are falling into reliable hands.

Update Oct,7 2:07 EDT:

From Reuters here,

CME Group (CME.O: Quote, Profile, Research, Stock Buzz) and Citadel
Investment Group said on Tuesday they are creating a platform
for electronic trading of credit default swaps, amid calls by
regulators to migrate trading of the $55 trillion private
market onto exchanges.

(…)

CME Group and Citadel will launch a joint venture for the
platform within 30 days, and are offering major participants in
the market equity stakes in the company to encourage them to
support trading on the exchange.