According to Bill Gross, a fixed income market guru, the size of the credit default swap market is "$43 trillion, more that half the size of the entire asset base of the global banking system." If that is not scary enough he goes on to tell is that "total derivatives amount to over $500 trillion, many of them finding their way"......................well, everywhere.
You are going to be hearing a lot more about these markets in coming weeks and months, which begs the question, why don't most people even know what they are? And more importantly, why should we care?
Bill Gross is a very senior guy at PIMCO, one of the largest fixed income managers in the world. They boast managing over $700 billion of assets, and in my experience as an ex-Goldman Sachs bond trader, they generally do it very well. Bill has been talking for a while now about the "Shadow Banking System" that has developed, which now dwarfs the traditional banking system. He describes how "our modern shadow banking system craftily dodges the reserve requirements of traditional institutions and promotes a chain letter, pyramid scheme of leverage, based in many cases on no reserve cushion whatsoever." Participants in this shadow banking system are in the business of making money, much like their more regulated cousins. They borrow money, leverage it up, and invest in assets to make a positive spread. Sounds simple, until things start to go wrong in the underlying asset, which of course is what is happening now.
At the center of this system is a product little known outside of the world of fixed income traders and investors, called Credit Default Swaps. According to Wikepedia, a "credit default swap (CDS) is a bilateral contract under which two counterparties agree to isolate and separately trade the credit risk of at least one third-party reference entity. Under a credit default swap agreement, a protection buyer pays a periodic fee to a protection seller in exchange for a contingent payment by the seller upon a credit event (such as a default or failure to pay) happening in the reference entity. When a credit event is triggered, the protection seller either takes delivery of the defaulted bond for the par value (physical settlement) or pays the protection buyer the difference between the par value and recovery value of the bond (cash settlement).
Credit default swaps resemble an insurance policy, as they can be used by debt owners to hedge against credit events. However, because there is no requirement to actually hold any asset or suffer a loss, credit default swaps can be used to speculate on changes in credit spread.
Credit default swaps are the most widely traded credit derivative product. The typical term of a credit default swap contract is five years, although being an over-the-counter derivative, credit default swaps of almost any maturity can be traded. "
Now what part of that description did you find the scariest? Was is the fact that this market is $43 trillion according to Gross? Or that all the contracts are based on the CREDIT of the underlying asset? Or the contingent payment based upon a credit event? Or the fact that in most cases the seller can ask for delivery of the defaulted bond? Or that there is no requirement to actually hold any asset or suffer a loss? Each of these questions could take pages and pages to dissect.
The whole system is obviously based on the assumption that your counter-party can in fact make good on the trade. That is why banks are moving quickly to check their counter-party risk and up shore up margin requirements. The prices of the underlying securities have been going down, making net net, some people winners, and some losers. It is the losers we need to worry about as they need to make good on their part of the trade, but will they have the money, the capital, to do so?
As an ex-trader I also find the part about the seller requesting delivery of the security to be particularly alarming. My old trader rule book tells me that you only sell (short) expensive bonds when you have locked up the borrowing, or else you get caught in something called a short squeeze. Knowing that these underlying bonds/loans can be synthetically created at a huge multiple of the underlying asset depending on demand for that asset, this could be really, really, really costly to many, and be very profitable for a few.
Given the size of the market, and the lack of transparency as to who owns what, we really have no idea about the financial impact caused by the deterioration of the underlying assets. This is why we care. One can not look at history to help figure this out either, as we have never had so much credit product outstanding. Where we are currently in the credit markets is fresh territory, uncharted waters, the wild west. The system is so complex and interconnected that it is absolutely impossible for anyone, any firm, any anything, to get their arms around it. Smart people are going to figure out a way to make money from this uncertainly, and less smart people are going to lose a lot.
Bill Gross is warning of the possibility of financial Armageddon as a result of this financial pyramid scheme, along the same line that George Soros, another billionaire who generally knows what he is talking about, came out about a few weeks ago. Both of these wizards of Wall Street have been known to talk to their position, but that does not mean they are not right.
I can't help but think of the movie, The Game, starring Michael Douglas as the playboy multi-millionaire, Nicholas. He thinks he is getting a present from his brother, a Game, that will change his life. "As the movie progresses, evidence mounts that the game is actually an elaborate scheme, but each time Nicholas thinks he has uncovered the truth, he finds a new layer of complexity has been revealed and that his previous assumptions were false."
Let's hope that enough pieces of this financial story get revealed in a timely way to prevent anyone from losing their faith in the overall system. There can be a happy ending, but like Nicholas, Bill, George and others, are having a hard time figuring it out.