Tuesday, February 21, 2012

Guest Post: A Simple Explanation of CDS

From Crazy Canuck:

Here is how the counterfeit value derivative con works. It’s a game of “I pretend, you pretend, we all pretend, and the taxpayer will pay in the end”.

I’ll create an instrument, say a credit default swap (CDS), an unregulated insurance with no capital requirements, with a certain “notional” value. Notional value is just something I assign. It does not have to be attached to or backed by any real asset or actual money/principal, but I can pretend as if it is. (Notional amount.)

As a seller, I will just declare that this swap covers the full value X of this company, contract, etc. if credit event Y happens. I receive lucrative insurance premiums and fees for my un-backed promise. The CDS’s value is based in nothing more than my promise to pay. I don’t have to have adequate capital reserves on hand, but I can pretend as if I do perhaps with some mini-reserves based on objective-seeming risk ratios calculated by my mathematical models. (credit default swap.)

As a buyer, you can then buy as many of these CDS’s as you want, even for a single default. If you are really sure something is going to tank you can insure it 30 times over (or a 100 or 1,000) and get 30 (or 100 or 1,000) times the return when it goes bust! In regulated insurance it is unacceptable to insure beyond the full replacement value of the underlying asset. Not so with CDS’s. The seller has gotten 30x the premiums and the buyer gets 30x value in the event of default. As a buyer of this phony “insurance” you don’t have a stake in the affected properties, but you can essentially pretend you do.

As buyer and seller of CDS’s either one of us can assign our risks to a third party through another contract, and pretend as if we are covered in case our own game playing blows up in our faces. This allows us to retain even less reserve capital and spend freed-up funds on more high-risk, high-(pseudo) return speculation. (The monster that ate Wall Street.)

We can purchase and sell of these derivative contracts to each other at unlimited rates to generate massive volume and huge fees and profits. We can simply hyper-cycle risk and take our chunk each time.

This is why they bailed out Greece....to avoid a payout of 30 something trillion.

I flipping hate banksters!