After reading about credit default swaps - One needed regulation becomes evident

[Phoebe Loosinhouse]

Here is some basic info about credit default swaps- if you choose not to plod through the density of the financial verbiage, I've translated it to real world example below. Skip to the **** paragraphs

http://en.wikipedia.org/wiki/Credit_default_swap
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Hedging
Credit default swaps can be used to manage credit risk without necessitating the sale of the underlying cash bond. Owners of a corporate bond can protect themselves from default risk by purchasing a credit default swap on that reference entity.

For example, a pension fund owns $10 million worth of a five-year bond issued by Risky Corporation. In order to manage the risk of losing money if Risky Corporation defaults on its debt, the pension fund buys a CDS from Derivative Bank in a notional amount of $10 million that trades at 200 basis points. In return for this credit protection, the pension fund pays 2% of 10 million ($200,000) in quarterly installments of $50,000 to Derivative Bank. If Risky Corporation does not default on its bond payments, the pension fund makes quarterly payments to Derivative Bank for 5 years and receives its $10 million loan back after 5 years from the Risky Corporation. Though the protection payments reduce investment returns for the pension fund, its risk of loss in a default scenario is eliminated. If Risky Corporation defaults on its debt 3 years into the CDS contract, the pension fund would stop paying the quarterly premium, and Derivative Bank would ensure that the pension fund is refunded for its loss of $10 million (either by taking physical delivery of the defaulted bond for $10 million or by cash settling the difference between par and recovery value of the bond). Another scenario would be if Risky Corporation's credit profile improved dramatically or it is acquired by a stronger company after 3 years, the pension fund could effectively cancel or reduce its original CDS position by selling the remaining two years of credit protection in the market.

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The market for credit derivatives is now so large, in many instances the amount of credit derivatives outstanding for an individual name are vastly greater than the bonds outstanding. For instance, company X may have $1 billion of outstanding debt and $10 billion of CDS contracts outstanding. If such a company were to default, and recovery is 40 cents on the dollar, then the loss to investors holding the bonds would be $600 million. However the loss to credit default swap sellers would be $6 billion. When the CDS have been made for purely speculative purposes, in addition to spreading risk, credit derivatives can also amplify those risks.If the CDS were being used to hedge, the notional value of such contracts would be expected to be less than the size of the outstanding debt as the majority of such debt will be owned by investors who are happy to absorb the credit risk in return for the additional spread or risk premium.

You can see how they can fulfill an actual need and could be real risk protection and insurance if used in the manner described under Hedging.

The problem arises when they are used not as a re-insurance by actual bond holders but as a purely speculative vehicle by people who
are not buying the bonds, but just making bets on the credit worthiness of the company issuing the bonds. And then there are so many people just willing to make these types of bets that it explodes far beyond the boundaries of the original intent.

****It's as though I loaned my neighborA 10K. I start to get a little uncomfortable about the loan and I talk to neighborB who says,hey, give me 1K and if the guy defaults, I'll make sure you get the whole 10K back. Now I'm out 11K, but at least I know that at the very worst, I'll get at least 10K back. If the neighbor I loaned the original money to does pay me back, well, I'm out the 1K to NeighborB, and I've limited my gain to just 9K total plus whatever interest I earned. The deal reduced my earnings on the loan, but I could sleep at night. NeighborB is pleased because he just made 1K and didn't put out any money himself - pure profit. Sweet!

****Where it goes horribly wrong is when all the neighbors on my street hear about the loan and start saying, Hey, do you think neighbor A is going to pay Phoebe back that 10K? And then they all start making bets with each other about whether that will happen or not.
Soon, my little 10K loan to my neighbor has over 200K on my street tied up over the answer to that question, and these guys weren't even involved in the first place! They're just betting on the outcome. And no money will actually pass hands until the outcome is known. My neighbors have just given each other IOU's. They could just as easily be betting on a football game, but they've decided to bet on my loan.

****So, the regulation that needs to be made is, no more neighbors not actually involved in the loan betting on the outcome and giving each other IOU's.

****On Wall Street - no one gets a credit default swap unless they are an actual bondholder really looking to hedge some real risk. Gamblers and speculators can go back to betting on football like the rest of us instead of taking down the global credit markets with their funny money!!!


edited - called a gain a loss by mistake in original.

[Wilber_Stool]

1. And these bets,

while in progress, are considered to be assets and prop up the value of the company.

I think.