Credit Default Swaps 2

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Credit Default Swaps 2

So let's see if we can get a big picture of everything that's happening in this credit default swap market.

I'll speak in generalities.

Let's say we have Corporation A, Corporation B, Corporation C.

And let's say we have a bunch of people who write the credit default swaps, and I'll call them insurers.

Because that's essentially what a credit default swap is, it's insurance on debt.

If someone doesn't pay the debt, then the insurance company will pay it for you.

In exchange, you're essentially giving some of the interest on the debt.

So let's say we have Insurer 1, let's say we have Insurer 2.

And some of these were insurance companies, some of these were banks.

Some of these may have even been hedge funds.

So these are the people who write the credit default swaps, and then there are the people who would actually buy the credit default swaps.

In the previous example, I had Pension Fund 1, that was my pension fund.

Then you could have another pension fund, Pension Fund 2.

Let's re-draw some of the connections between the organizations.

Let's say Pension Fund 1 were to lend $1 billion to A.

A will pay Pension Fund 1 10%.

But Pension Fund 1 wants to make sure that they'll definitely get the money, because they can't lend money to people with anything less than stellar credit ratings.

So they get some insurance from Insurer 1.

So what they do is out of this 10%, they pay them some of the basis points.

So let's say they pay them 100 basis points.

And in exchange, they get - I'll call it Insurance On A.

This is this new notation that I'm creating.

They get Insurance On A.

Fair enough.

And the reason why this I1, this first insurer was able to do that is because Moody's has given them a very high credit rating.

And so when they insure something, you're essentially the total package, right?

The loan to this guy, plus the insurance, kind of is like you're lending the money to this guy, but you're just getting more insurance - I mean you're getting more interest, right?

So this bond becomes a Double A bond.

Because the odds that you are not going to get your money are not the odds that this guy defaults, but it's now the odds that this guy defaults.

And Moody's or Standard & Poor's have already said.

Hey, these guys are good for their money, they're Double A or whatever.

So now your risk is really a Double A risk and not a Double B risk, or whatever.

But anyway, this happens.

This is Corporation B, and maybe Pension Fund 2 wants to lend to Corporation B.

Maybe they lend them $2 billion.

They get, I don't know, they get 12%, maybe Corporation B is a little bit more dangerous.

But once again, they go to this first insurer.

And maybe they get some of it - well let's just say they get Insurance On B.

And B is a little bit riskier, so they have to pay 200 basis points.

200 basis points goes from Pension Fund 2 to B.

Now this, already, this is a little bit dangerous, right?

Because you can think about what's happening.

One, as long as this insurer does not get a downgrade from their credit ratings from S&P or Moody's or whoever, they can just keep it issuing this insurance.

There's no limit for how much insurance they can issue.

There's no law that says, you know what, if you insure a billion dollars of debt, you have to put a billion dollars aside.

So that if that debt defaults, you definitely have that billion dollars there.

Or if you insure 2 billion here, you don't have to put that 2 billion aside.

What you have is a bunch of people who statistically say, oh, you know, what's the probability that all of this debt defaults?

So I just have to keep enough capital so that probabilistically, whatever debt defaults, I can pay it.

But you don't keep enough capital to pay all of the defaulting debt.

So you already see an interesting risk forming.

What if all of these corporations, for whatever reason, do start defaulting simultaneously?

Then all of a sudden this insurance company has to pay more out in insurance then it might even have.

So you have to wonder whether it even deserves this Double A rating, because it actually is taking on a lot of risk.

But in the short term, while these companies are - everyone is doing well and the economy's doing well, it's a great business for these guys.

These guys are just collecting premiums essentially on the insurance, without having to pay out anything.

Now let's add another twist on it.

These pension funds, P1 and P2, it was reasonable for them to get insurance, because they were giving out these loans and then they got the insurance.

So they were essentially hedging the default risk by buying these credit default swaps, which was essentially just an insurance policy from this Insurer 1.

But you can have another party.

This is no less legitimate, really.

But you could call them - I don't know - let's call it Hedge Fund 1.

And they've done a lot of work, and frankly, they often are much more sophisticated than the pension fund - in fact, they almost always are.

And they say, you know what?

Company B looks really, really, really, really shady.

I think 200 basis points for the chance that Company B defaults is frankly cheap.

Because I think there's a huge probability that Company B defaults.

So what I'm going to do, I'm not going to lend Company B money, because if anything, I think that they're maybe about to go out of business.

But what I can do is I can buy a credit default swap on Company B's debt.

Which is, essentially, I'm getting insurance that they fail without actually lending the money.

So let's say I do that from Insurer 2.

So I can go and I'll pay Insurer 2 200 basis points a year, or 2% on the notional value of the insurance I'm getting.

So let's say it's 200 basis points, and let's say that's Insurance On - I'm making a big bet - so they're going to give me Insurance On B for - I don't know - $10 billion.

And something interesting is going on here already.

B might not have even borrowed $10 billion, right?

So all of a sudden you have this hedge fund that is getting insurance on more debt than B has even borrowed money on, right?

And it's essentially, you just kind of have this side bet between these two parties.

This party says, you know what?

I think it's a good deal.

I get 200 basis points on the 10 billion every year, as long as B doesn't default.

And this guy says, I think B's going to default.

So I think that's a good deal on that insurance.

And just so you understand the math, so the notional value is $10 billion.

So what's 2% of 10 billion?

2% on a billion is 20 million, so it's $200 million.

200 if I did my math correct.

So they'll pay $200 million a year to this insurer.

So the 200 basis points on 10 billion is equal to 200 million.

These numbers maybe are a little bit on the big side, but who knows?

Actually, this could be a huge hedge fund.

This could be a $10 billion hedge fund.

Or even worse, maybe it's a billion dollar hedge fund, or maybe it's a $20 million hedge fund, but they've taken a $180 million loan to essentially buy this insurance because they think that B's collapse is imminent.

So they're willing to take that bet right now.

You know, it might be a good bet.

If B collapses tomorrow, what's going to happen?

They only dished out maybe 200 million for maybe that first year, although you normally pay it on a quarterly basis.

So they'll pay 50 million every three months.

Let's say they pay the first payment, 50 million, right?

And then over the next three months, B just goes bankrupt and people realize that debt was worth nothing.

Then these guys get $10 billion.

Right?

But something else is interesting here.

They probably did insurance to a lot of other people too, maybe on B's debt.

Right?

Or maybe they also insured A's debt.

So maybe they gave some insurance on A's debt, as well.

So what happens?

Let's say B all of a sudden defaults.

So a couple of things happen.

I1 is going to owe P2.

$2 billion, right?

I2, the second insurer, is going to owe this hedge fund $10 billion.

Now let's just assume I2's good for the money.

They have $10 billion they pay to this hedge fund.

This hedge fund is great, they get great bonuses for the year and they go buy yachts, et cetera.

But this insurer right here, they pay the money they were good for but something interesting might happen.

All of a sudden Moody's finally wakes up, these ratings agencies, and says, oh, my God.

Well, there's a couple of things that might make them say, oh, my God.

First of all, they might say, oh, look.

You have to pay out $10 billion.

And I doubt that was the only person you have to pay, maybe they have to pay out a lot of money.

Now I2, Insurance Company 2, you are undercapitalized.

I am now going to downgrade your rating.

So, you were Double A, but since you had to give out all of this capital, Moody's is now going to downgrade you to, I don't know, B+.

I'm just making these ratings up.

But that's the sound of how these ratings happen, right.

A is better, B is worse.

The more A's you have, the better it is.

But all of a sudden, when this guy is B+, and this guy insured, let's say, some other corporation's debt for this pension fund, now all of a sudden this insurance that this pension fund had is no longer Double A Insurance.

It's now B+ Insurance, and maybe this pension fund, by its charter, can't hold something that has a B+ credit rating.

So they're going to have to unwind the transaction, or maybe they'll have to unload the debt that was insured.

So one, just by Company B defaulting, maybe this guy was holding some of Company A's debt, and it was insured by Insurance Company 1.

Now they're going to have to unload that debt.

So just one default creates this chain reaction, right?

This one default happens, this guy has to pay this guy money, then this guy gets undercapitalized since they have to pay out money.

Then Moody's says, oh, my God, you're undercapitalized.

We're going to reduce your ratings.

Maybe this guy was insuring some of A's debt, but now since he was insuring some of A's debt, all of a sudden that insurance is worth less because it has a lower rating.

And now A's debt, less people want to hold it, because there are less people to insure it.

I know that's very confusing, but this is really the point that Warren Buffett was saying when he said that the credit defaults swap market, or in general, the derivative market, are financial weapons of mass destruction.

Because you have so many people who didn't have to set aside a capital, right?

This guy could insure $10 billion worth of debt without having to set aside $10 billion.

And you have so many people making all of these side bets, but they're all making two core assumptions.

One, that these rating agencies' ratings are valid.

And two, that the other person is good for the money.

But if all of a sudden you have one failure someplace in the system, you could have this cascade where one, there's just a lot of downgrades.

And then a lot of the people end up not being good for the money.

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Credit Default Swaps 2발음듣기

다른 번역문 등록

So let's see if we can get a big picture of everything that's happening in this credit default swap market.발음듣기

다른 번역문 등록

I'll speak in generalities.발음듣기

다른 번역문 등록

Let's say we have Corporation A, Corporation B, Corporation C.발음듣기

다른 번역문 등록

And let's say we have a bunch of people who write the credit default swaps, and I'll call them insurers.발음듣기

다른 번역문 등록

Because that's essentially what a credit default swap is, it's insurance on debt.발음듣기

다른 번역문 등록

If someone doesn't pay the debt, then the insurance company will pay it for you.발음듣기

다른 번역문 등록

In exchange, you're essentially giving some of the interest on the debt.발음듣기

다른 번역문 등록

So let's say we have Insurer 1, let's say we have Insurer 2.발음듣기

다른 번역문 등록

And some of these were insurance companies, some of these were banks.발음듣기

다른 번역문 등록

Some of these may have even been hedge funds.발음듣기

다른 번역문 등록

So these are the people who write the credit default swaps, and then there are the people who would actually buy the credit default swaps.발음듣기

다른 번역문 등록

In the previous example, I had Pension Fund 1, that was my pension fund.발음듣기

다른 번역문 등록

Then you could have another pension fund, Pension Fund 2.발음듣기

다른 번역문 등록

Let's re-draw some of the connections between the organizations.발음듣기

다른 번역문 등록

Let's say Pension Fund 1 were to lend $1 billion to A.발음듣기

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A will pay Pension Fund 1 10%.발음듣기

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But Pension Fund 1 wants to make sure that they'll definitely get the money, because they can't lend money to people with anything less than stellar credit ratings.발음듣기

다른 번역문 등록

So they get some insurance from Insurer 1.발음듣기

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So what they do is out of this 10%, they pay them some of the basis points.발음듣기

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So let's say they pay them 100 basis points.발음듣기

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And in exchange, they get - I'll call it Insurance On A.발음듣기

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This is this new notation that I'm creating.발음듣기

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They get Insurance On A.발음듣기

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Fair enough.발음듣기

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And the reason why this I1, this first insurer was able to do that is because Moody's has given them a very high credit rating.발음듣기

다른 번역문 등록

And so when they insure something, you're essentially the total package, right?발음듣기

다른 번역문 등록

The loan to this guy, plus the insurance, kind of is like you're lending the money to this guy, but you're just getting more insurance - I mean you're getting more interest, right?발음듣기

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So this bond becomes a Double A bond.발음듣기

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Because the odds that you are not going to get your money are not the odds that this guy defaults, but it's now the odds that this guy defaults.발음듣기

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And Moody's or Standard & Poor's have already said.발음듣기

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Hey, these guys are good for their money, they're Double A or whatever.발음듣기

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So now your risk is really a Double A risk and not a Double B risk, or whatever.발음듣기

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But anyway, this happens.발음듣기

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This is Corporation B, and maybe Pension Fund 2 wants to lend to Corporation B.발음듣기

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Maybe they lend them $2 billion.발음듣기

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They get, I don't know, they get 12%, maybe Corporation B is a little bit more dangerous.발음듣기

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But once again, they go to this first insurer.발음듣기

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And maybe they get some of it - well let's just say they get Insurance On B.발음듣기

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And B is a little bit riskier, so they have to pay 200 basis points.발음듣기

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200 basis points goes from Pension Fund 2 to B.발음듣기

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Now this, already, this is a little bit dangerous, right?발음듣기

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Because you can think about what's happening.발음듣기

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One, as long as this insurer does not get a downgrade from their credit ratings from S&P or Moody's or whoever, they can just keep it issuing this insurance.발음듣기

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There's no limit for how much insurance they can issue.발음듣기

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There's no law that says, you know what, if you insure a billion dollars of debt, you have to put a billion dollars aside.발음듣기

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So that if that debt defaults, you definitely have that billion dollars there.발음듣기

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Or if you insure 2 billion here, you don't have to put that 2 billion aside.발음듣기

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What you have is a bunch of people who statistically say, oh, you know, what's the probability that all of this debt defaults?발음듣기

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So I just have to keep enough capital so that probabilistically, whatever debt defaults, I can pay it.발음듣기

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But you don't keep enough capital to pay all of the defaulting debt.발음듣기

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So you already see an interesting risk forming.발음듣기

다른 번역문 등록

What if all of these corporations, for whatever reason, do start defaulting simultaneously?발음듣기

다른 번역문 등록

Then all of a sudden this insurance company has to pay more out in insurance then it might even have.발음듣기

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So you have to wonder whether it even deserves this Double A rating, because it actually is taking on a lot of risk.발음듣기

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But in the short term, while these companies are - everyone is doing well and the economy's doing well, it's a great business for these guys.발음듣기

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These guys are just collecting premiums essentially on the insurance, without having to pay out anything.발음듣기

다른 번역문 등록

Now let's add another twist on it.발음듣기

다른 번역문 등록

These pension funds, P1 and P2, it was reasonable for them to get insurance, because they were giving out these loans and then they got the insurance.발음듣기

다른 번역문 등록

So they were essentially hedging the default risk by buying these credit default swaps, which was essentially just an insurance policy from this Insurer 1.발음듣기

다른 번역문 등록

But you can have another party.발음듣기

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This is no less legitimate, really.발음듣기

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But you could call them - I don't know - let's call it Hedge Fund 1.발음듣기

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And they've done a lot of work, and frankly, they often are much more sophisticated than the pension fund - in fact, they almost always are.발음듣기

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And they say, you know what?발음듣기

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Company B looks really, really, really, really shady.발음듣기

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I think 200 basis points for the chance that Company B defaults is frankly cheap.발음듣기

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Because I think there's a huge probability that Company B defaults.발음듣기

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So what I'm going to do, I'm not going to lend Company B money, because if anything, I think that they're maybe about to go out of business.발음듣기

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But what I can do is I can buy a credit default swap on Company B's debt.발음듣기

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Which is, essentially, I'm getting insurance that they fail without actually lending the money.발음듣기

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So let's say I do that from Insurer 2.발음듣기

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So I can go and I'll pay Insurer 2 200 basis points a year, or 2% on the notional value of the insurance I'm getting.발음듣기

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So let's say it's 200 basis points, and let's say that's Insurance On - I'm making a big bet - so they're going to give me Insurance On B for - I don't know - $10 billion.발음듣기

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And something interesting is going on here already.발음듣기

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B might not have even borrowed $10 billion, right?발음듣기

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So all of a sudden you have this hedge fund that is getting insurance on more debt than B has even borrowed money on, right?발음듣기

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And it's essentially, you just kind of have this side bet between these two parties.발음듣기

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This party says, you know what?발음듣기

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I think it's a good deal.발음듣기

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I get 200 basis points on the 10 billion every year, as long as B doesn't default.발음듣기

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And this guy says, I think B's going to default.발음듣기

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So I think that's a good deal on that insurance.발음듣기

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And just so you understand the math, so the notional value is $10 billion.발음듣기

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So what's 2% of 10 billion?발음듣기

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2% on a billion is 20 million, so it's $200 million.발음듣기

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200 if I did my math correct.발음듣기

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So they'll pay $200 million a year to this insurer.발음듣기

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So the 200 basis points on 10 billion is equal to 200 million.발음듣기

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These numbers maybe are a little bit on the big side, but who knows?발음듣기

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Actually, this could be a huge hedge fund.발음듣기

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This could be a $10 billion hedge fund.발음듣기

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Or even worse, maybe it's a billion dollar hedge fund, or maybe it's a $20 million hedge fund, but they've taken a $180 million loan to essentially buy this insurance because they think that B's collapse is imminent.발음듣기

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So they're willing to take that bet right now.발음듣기

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You know, it might be a good bet.발음듣기

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If B collapses tomorrow, what's going to happen?발음듣기

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They only dished out maybe 200 million for maybe that first year, although you normally pay it on a quarterly basis.발음듣기

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So they'll pay 50 million every three months.발음듣기

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Let's say they pay the first payment, 50 million, right?발음듣기

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And then over the next three months, B just goes bankrupt and people realize that debt was worth nothing.발음듣기

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Then these guys get $10 billion.발음듣기

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Right?발음듣기

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But something else is interesting here.발음듣기

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They probably did insurance to a lot of other people too, maybe on B's debt.발음듣기

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Right?발음듣기

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Or maybe they also insured A's debt.발음듣기

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So maybe they gave some insurance on A's debt, as well.발음듣기

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So what happens?발음듣기

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Let's say B all of a sudden defaults.발음듣기

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So a couple of things happen.발음듣기

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I1 is going to owe P2.발음듣기

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$2 billion, right?발음듣기

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I2, the second insurer, is going to owe this hedge fund $10 billion.발음듣기

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Now let's just assume I2's good for the money.발음듣기

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They have $10 billion they pay to this hedge fund.발음듣기

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This hedge fund is great, they get great bonuses for the year and they go buy yachts, et cetera.발음듣기

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But this insurer right here, they pay the money they were good for but something interesting might happen.발음듣기

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All of a sudden Moody's finally wakes up, these ratings agencies, and says, oh, my God.발음듣기

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Well, there's a couple of things that might make them say, oh, my God.발음듣기

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First of all, they might say, oh, look.발음듣기

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You have to pay out $10 billion.발음듣기

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And I doubt that was the only person you have to pay, maybe they have to pay out a lot of money.발음듣기

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Now I2, Insurance Company 2, you are undercapitalized.발음듣기

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I am now going to downgrade your rating.발음듣기

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So, you were Double A, but since you had to give out all of this capital, Moody's is now going to downgrade you to, I don't know, B+.발음듣기

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I'm just making these ratings up.발음듣기

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But that's the sound of how these ratings happen, right.발음듣기

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A is better, B is worse.발음듣기

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The more A's you have, the better it is.발음듣기

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But all of a sudden, when this guy is B+, and this guy insured, let's say, some other corporation's debt for this pension fund, now all of a sudden this insurance that this pension fund had is no longer Double A Insurance.발음듣기

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It's now B+ Insurance, and maybe this pension fund, by its charter, can't hold something that has a B+ credit rating.발음듣기

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So they're going to have to unwind the transaction, or maybe they'll have to unload the debt that was insured.발음듣기

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So one, just by Company B defaulting, maybe this guy was holding some of Company A's debt, and it was insured by Insurance Company 1.발음듣기

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Now they're going to have to unload that debt.발음듣기

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So just one default creates this chain reaction, right?발음듣기

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This one default happens, this guy has to pay this guy money, then this guy gets undercapitalized since they have to pay out money.발음듣기

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Then Moody's says, oh, my God, you're undercapitalized.발음듣기

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We're going to reduce your ratings.발음듣기

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Maybe this guy was insuring some of A's debt, but now since he was insuring some of A's debt, all of a sudden that insurance is worth less because it has a lower rating.발음듣기

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And now A's debt, less people want to hold it, because there are less people to insure it.발음듣기

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I know that's very confusing, but this is really the point that Warren Buffett was saying when he said that the credit defaults swap market, or in general, the derivative market, are financial weapons of mass destruction.발음듣기

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Because you have so many people who didn't have to set aside a capital, right?발음듣기

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This guy could insure $10 billion worth of debt without having to set aside $10 billion.발음듣기

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And you have so many people making all of these side bets, but they're all making two core assumptions.발음듣기

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One, that these rating agencies' ratings are valid.발음듣기

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And two, that the other person is good for the money.발음듣기

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But if all of a sudden you have one failure someplace in the system, you could have this cascade where one, there's just a lot of downgrades.발음듣기

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And then a lot of the people end up not being good for the money.발음듣기

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