Wednesday Oct 15, 2008

Have you ever heard of Credit Default Swaps?

Have you had enough yet of all the discussions, opinions, suggestions, agendas and lunacy regarding the stock market?  I've been watching for a while what is the ultimate effect of credit default swaps (CDS).  It is rumored that there are approximately trillions (U.S. dollars) worth of these puppies lurking out there.  That is no typo, yes trillions not billions worth of these unregulated contracts between a buyer and seller.  Some estimates put CDS liability up to $60 trillion U.S. dollars.  Basically CDS are insurance contracts if a credit instrument (e.g. bonds) defaults.  They cannot technically be called insurance because they are unregulated.  Since they are unregulated there is no requirement to report or track these instruments.  That's sounds a little broken you would think.

A good example is Lehman Brothers.  Lehman's bonds recently have traded for less than $.20 (U.S. dollars).  That means the seller of CDS on these bonds are liable to payoff the other $.80 (U.S. dollars).  These payoffs are going to absolutely impact negatively the institutions that issued the CDS. Instruments such as the CDS have complex probability mathematics behind them.  Created by intellects who went to work on Wall Street. Definitely something I'd personally stay away.  The derivative market is clearly not for the faint of heart. Trouble has been brewing for a while as reporting has disclosed.  The cascading effect across the world was obvious.  I don't know how some could say that this was a U.S. economy only problem.  Markets and investors worldwide are ultimately linked as a result of technology.  Investment options are available to almost anyone, anywhere via the access of a computer.  In my opinion the complex automated trading algorithms of buy .vs sell in the market do not take into account the variable of human fear.  How does a computer program stop a run on the bank without human intervention? That is intervention coordinated with complaint on a global level.   Would love to know where money is flowing to and where it is flowing from...  I'd guess it is flowing to banks where governments are insuring deposits and from banks where there is none.    Have we thought through the long term effects yet?  Truly fascinating.


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The blog of Bob Porras - Vice President, Data, Availability, Scalability & HPC for Sun Microsystems, Inc.

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