“[C]redit default swaps are not normal insurance policies, each side can trade them to make a quick profit (spread) if there is a willing counterparty [emphasis added]. Commonly after the original CDS contract is engaged, each side of the original two parties will try to engage another party to further hedge their bet and earn a small spread, pretty soon there are layers of layers of counterparties involved, with total notional amount increasing several fold, and no one knows who they are really dealing with anymore.”
(snip)
“The market cap of GM is only about $11B. However, based on estimates in the CDS market, there are about $1 trillion in CDSs betting on GM and their bonds. Any change in GM's situation, will create a rippling effect in this $1T CDS community of GM.”
“There are obviously not $1T of GM properties to act as collateral, so you have to trust all parties involved in this wild casino betting that they won't go under water. As a matter of fact, you better pray, because if one goes under, which is a high probability event, it throws a monkey wrench in the whole community, as everyone is trying to rewind and get out at the same time. It becomes a ‘no way out situation’”.
So Tan explains how trading of CDS with the idea of grabbing quick profits can have spun up the notional values of these CDS many times larger than their values when first issued.
Now the initial value of all freshly issued CDS is well enough known to be about $45 trillion, whereas in consequence to their having been extensively traded they are estimated to have ballooned to a notional value of as much as $500 trillion! Putting this into perspective, the U.S. GDP – and the U.S. money supply – is “only” about $15 trillion, the GDPs of all nations in the world sum to approximately $50 trillion, and the total value of world's stock and bond markets is “only” slightly more than $100 trillion.
So, far, far worse than taxpayer bailout funds being used to pay just the bonuses to the very folks responsible for this mess, it is strongly looking as though much of the bailout moneys going to A.I.G., Goldman Sachs, USB, and other big banks may be largely to pay off counterparties to CDS contracts. If so, then the government is using taxpayer money as a down payment on a debt – not of the taxpayers’ making – amounting to 3 to 33 times the current U.S. money supply!
Given the impossibility of ever paying such a debt in full without driving the dollar below the Mexican peso, it is high time to declare the taxpayers bankrupt, pay the winning counterparties to the CDS a few taxpayer pennies on the dollar – or better still nothing at all (after all it was the banks, not the taxpayers who were engaged in this reckless form of gambling) – and then restart the economy the way Paul Krugman has laid out.
Post Script: On Monday George Soros published a very instructive column in the Wall Street Journal explaining the perils of CDS and explaining how A.I.G. went wrong, concluding that “CDS are toxic instruments whose use ought to be strictly regulated” by requiring that “Only those who own the underlying bonds ought to be allowed to buy them.” But future regulation will not get us out of the current mess ...that is unless these regulations were to be applied retroactively.
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