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If you thought the sub-prime mess was bad...

COMMENTARY | June 06, 2008

Credit default swaps, a relatively new form of protection for lenders, constitute an international market so huge -- $62 trillion -- that a credit default in it could cause financial institutions to stop lending, paralyzing the economic system.

By Henry M. Banta

As the sub-prime mortgage crisis moves along we are treated to a daily play-by-play account. Losses by financial institutions, write-offs by banks, and every minor fluctuation in the real estate and housing markets make the front pages and the evening news. But there may be another financial story we should be watching more closely.

The sub-prime mortgage crisis was a matter of a lot of mortgages and pieces of mortgages being traded at prices above their real value, or whose real value could not be determined. The whole mortgage backed securities market was about $6.5 trillion. According to Bloomberg, the financial institutions have lost $382 billion to date – serious money by any standard. But readers of the business press and the inside pages of business sections are aware that there is a huge international market for another kind of financial instrument – credit default swaps (CDS). These are like insurance policies that cover lenders – banks, bondholders – in the event that companies fail to pay their debts. If a company fails to meet its debt obligations the lenders will be made whole.  From the perspective of the issuers, CDS are like bets on whether a particular loan will be paid off. 

[Click here for a Time Magazine article on credit default swaps.]

The danger is that if there were a failure in the credit default swap market, i.e., if the parties who sell these kinds of guarantees are unable to meet their obligations, confidence in the system could be shaken. Since these instruments are sold and resold the uncertainty could paralyze the system..  Unsure of their capital positions, financial institutions might stop lending. It was the fear of this kind of paralyzing uncertainty that prompted the bail-out of Bear Sterns.

It has been widely, but not prominently, reported that the credit default swaps market was $45.5 trillion in 2007 – a number that the New York Times noted was about twice the size of the of the entire United States stock market. This is a shocking comparison to any one familiar with the financial world, but not likely to get the attention of the ordinary citizen. 

Let me suggest a comparison that might be easier to grasp. The purported value of the CDS market in 2007 was greater than the total of everything earned that year by every single person – man, woman and (unfortunately) child in the United States, China, Japan, India, Germany, the United Kingdom, Russia, France, Brazil, Italy, Spain, Mexico, and Canada. 

Last year the output of every living soul on the planet was only $65.8 trillion.  This year the CDS market purports to be worth $62.1 trillion. Doesn’t this raise some questions?

How can it possibly be worth that much?  Remember this is stuff that didn’t even exist ten years ago. Suppose they are not really worth $62 trillion? What then? The whole sub-prime market was only worth $6.5 trillion, and look what happened when it got into trouble. What will happen if a $62 trillion market gets into trouble? Who is at risk if the system unwinds? The issue sails into stunning complexity since the CDS are bought and sold by parties who are likely to be unrelated to the original parties. How does it all get sorted out?

This system was put together in a rising economy when the chances of any default on corporate debt were small. But if we learned anything from the real estate market, it is that it is insane to assume that whatever goes up will keep going up.

Aren’t there issues here that deserve some serious public discussion?  Might the media take their eyes off the Phoenix housing market long enough to give the issue some attention? Perhaps ask the presidential and House and Senate candidates a question or two about it? 

If war is too important to be trusted to generals . . . .

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