Frozen Credit Markets: What They Are Not Telling Us…

…And why they are not telling us. Those three toxic words driving the financial crisis and the credit freeze: credit default swaps (CDS). They cannot tell us because it is too big to comprehend and too hard to explain. CDS contracts are essentially bets on the bets on the bets that the underlying financial instruments, mainly mortgages, would continue to be profitable. The bets on the bets on the bets are a whole lot bigger number than the underlying mortgages themselves. MIT caliber mathematicians came up with those statistical models; risk moves towards zero when divided into infinitesimal slices shared by a greater mass of investors. Of course this is only good when underlying values increase; nobody calculated the downside. Whoops! First we have to understand credit default swaps...

From wikipedia:

“In layman’s terms the CDS is essentially an unregulated insurance policy. It guarantees the performance of a security instrument, e.g., a mortgage. The buyer of the CDS pays the maker a fee or “premium” (think insurance) for protection against a loss. Historically the US Treasury has not classified derivatives as “insurance,” and therefore they trade free of any government regulations. Because of that, the firm selling the CDS is not required to set aside any reserves from the premiums received to insure against possible future loss claims. This obviously makes the sale of the Credit Default Swaps extremely profitable and default loss payments very expensive.”

“Credit default swaps are the most widely traded credit derivative product. By the end of 2007 there was an estimated $45 trillion to $62.2 trillion worth of credit default swap contracts outstanding worldwide.

Today, AIG asked for even more money; we the taxpayers have already loaned them $85,000,000,000 then another $38,500.000.000 and now they want another $12,000,000,000. If you insert AIG in where it says "the firm" in the above quote then you will understand AIG’s problem. They sold a lot of CDS and all of those mortgage losses mean potentially trillions in loss claims; that’s a heck of a lot of payouts. Insurance is good when everyone pays premiums but only a few collect; there are simply too many people collecting due to these defaults. All of those failing mortgages mean billions, even trillions, in insured defaults.

Adam Davidson of NPR stated that “The pure size of the CDS business is enough to make a failure of AIG a threat to the entire global economy…The fear is…if AIG collapsed, banks would stop lending money to each other. The Treasury Secretary and the Federal Reserve Chairman, Paulson and Bernanke respectively, know this and that is why they keep pumping the money into the credit markets. Over $2,000,000,000,000 has been committed by the Treasury and the Fed so far but the banks are not budging, they are still not lending money to each other; the credit freeze is not thawing. With trillions of CDS sold, no one knows how deep it goes. All of this money may just be a drop in the bucket.

The next President is going to have to understand this because this economic chasm is like quicksand. It is going to swallow up a whole lot of dough. NPR tried to explain it and 60 Minutes tried to explain it but it is too monumental an amount to comprehend and maybe it is better if we don’t know and just hope that some institutions become greedy enough to start lending again. This is essentially what we are left with to solve this crisis, hope. Huge risks yield huge rewards, the American taxpayer has already taken on that premise. If we can convince more institutions to put equity into this new game then fear diminishes and lending begins. Thus, the big outlay on the part of banks around the world. But then again, maybe we shouldn’t be running on so much debt after all. What point expansion if the debt overcomes the gains in the end?