Crisis in Credit Default Swaps (CDS)

You think the US subprime crisis is big?? Wait till you take a look at the NEXT BIG CRISIS that will be caused by Credit Default Swaps (CDS) in a potential colossus problem! I mean sure the US subprime has cause losses to the tune of over US$200 billion… but the Credit Defaults Swaps are problems with the big T. Yes, the problems are in the trillions… or US$50 trillion to be exact! That is over 3 times the US GDP (US$13 Trillion) and many many times Malaysia’s GDP (don’t ask).

Credit Default Swaps (CDS) are financial instruments (or derivatives) to transfer the credit risk of fixed income products. The buyer of a CDS receives credit protection while a seller ‘guarantees’ the credit worthiness of the product. For example, ‘Mr. Investor Inc’ purchases a US$1bil bond from ‘Mr. In Need of Cash Inc’, but is not sure of its credit worthiness. So Mr. Investor Inc purchases a CDS from ‘Mr. Solid Bank Inc’ to transfer its credit risk by paying a premium of US$50 mil to Mr. Solid Bank Inc. At first, this seems like easy money for Mr. Solid Bank Inc as long as Mr. In Need of Cash Inc does not default. If there is a default, Mr. Solid Bank Inc will have to pay Mr. Investor Inc US$1bil if the bond is totally worthless.

Somewhere along the way Mr. Solid Bank Inc sold the CDS to ‘Mr. Hedge Fund Inc’ who in turn sold it to ‘Mr. Greedy Trader Inc’, who in turn sold it to ‘Mr. Speculator Inc’. If Mr. In Need of Cash Inc defaults and somewhere along the line Mr. Speculator Inc has no capability to cover the US$1bil in default, it will affect everyone along the line and you will find that Mr. Solid Bank Inc. will not be so solid anymore. So a potential US$1bil in losses are not just US$1bil in value but multiplied 4 times over (in this example) to US$4bil in write-downs. Of course, I am using a simplistic calculation for my illustration. But just to give you an idea on how big this problem is… the US commercial loan market is worth US$5 trillion but the volume of CDS outstanding is US$50 trillion. It simply means, CDS have changed hands and are traded many times over, thus further amplifying the problem.

If just 1% of the CDS in the market goes bust… somewhere in the financial system there will be US$ 500 billion in losses (far greater than subprime, so far). In fact, some companies that are already affected are American International Group (AIG) with CDS losses of US$11.5 billion and not forgetting that the top 25 banks in US holds more than US$ 13 trillion in Credit Default Swaps potentially triggering The Next Crisis. See the problem right now? Well they don’t call derivatives “financial weapons of mass destruction” for nothing. In the famous words of Warren Buffett himself; “…counterparties record profits and losses (often huge in amount) in their current earnings statement without so much as a penny changing hands. The range of derivatives contracts is limited only by the imagination of man (or sometimes, so it seems, madmen).”

If this is too much gloom for you in a day (sorry, about that mate)… why not take a look at a place which seems to defy the gloomy economic outlook? A place where luxury automobile dealers like Ferrari Maserati and Bentley Motors have arrived in this town. Land investments anyone?