Must read article on credit default swaps on seeking alpha

[alan_IHB]

Just came across this article explaining credit default swaps (CDS). CDS enabled Wall street banks to sell CDO's and pass the risk on to another party, thus explaining why wall street wanted to sell as many sub prime mortgages as possible because they were able to make money and pass on the risk. What's really interesting is that CDS also allowed wall street bankers to book the next 10 years worth of profits into the current year, which is how they got such huge end of year bonuses.



<a href="http://seekingalpha.com/article/73060-why-wall-st-needed-credit-default-swaps?ref=patrick.net#comment_form">Why Wall Street needed credit default swaps</a>

 

[Strom_IHB]

Very good article!

 

[vicstah_IHB]

"Bill Gross at PIMCO did a simple calculation in January at his famous article "Pyramid Crumbling". The total amount of CDS contracts is at $45 trillion. The historical default rate is 1.25%, or $500B CDS contracts will be in default. Assuming a recovery rate of 50%, the resulting loss is $250B alone.



I feel his assumptions are too optimistic. The assumed default rate is far too low if you consider the composition of underlying CDO products with many of them being subprime mortgages, which is unprecedented in the financial history. His recovery rate assumption is probably also far too high if you consider the long process of home foreclosure in a deteriorating real estate market with no buyers and legal tricks which can be implemented by homeowners (refer to my early articles on foreclosure). I won't be surprised to see the real losses doubling his estimate to be $500B total. "



Major WTF right there....

 

[awgee_IHB]

Have you ever wondered who was paying out on all those <a href="http://www.bloomberg.com/apps/news?pid=20601109&sid=aAqPKpl2zjkg&refer=home">credit default swaps</a>

 

[freedomCM_IHB]

Have you ever wondered how there could be $45T of swaps on the $12T housing market? They are just triple insuring the same asset. Some of the buyers of the CDS don't even own the CDOs, they are just gambling on the defaults.

 

[awgee_IHB]

[quote author="freedomCM" date=1240729856]Have you ever wondered how there could be $45T of swaps on the $12T housing market? They are just triple insuring the same asset. Some of the buyers of the CDS don't even own the CDOs, they are just gambling on the defaults.</blockquote>


Most credit default swaps are not written on mortgage backed securities. Most are written against corporate bonds, municipal and government bonds, and other bonds. But, there are many CDSes written against bonds for which the counter party is not holding.