No. of Recommendations: 79
<Would you lay out the consequences of a CDS cascade? All I can grasp is that it would be a Really Bad Thing.>

A CDS cascade would be a Really Bad Thing. Great way to put it.

A CDS (Credit Default Swap) is a private, unregulated insurance contract.

Let's say that I buy a bond, because I want the interest payments. Looking at Fidelity, today, here is one choice.

GE CAPITAL INTERNOTES 5.00000% 03/15/2017 FR
CUSIP 36966RW69

Coupon 5.000
Yield to Maturity 7.45%
Maturity Date 03/15/2017
Moody's Rating AAA
S&P Rating AAA

Wow, that looks like an excellent yield, especially given the high rating. But, even before the financial crisis started, there is always a possibility of default.

I phone you. "Meg, would you be able to insure the GE Capital Internotes? I will pay you $100 to insure $100,000 worth of notes."

You think, "Wow, what a deal! GE will never default on its notes. It's free money in my pocket."

So you answer, "Sure, Wendy, I'd be glad to insure your notes. Let's make a deal. You send me $100 for 5 years, and I will insure your notes."

I send you $100. Every year I send $100, just like any other kind of insurance. Now I can list my GE bond's asset value at par, regardless of market problems, because it's insured. I know that I will get at least my principal back, even if GE defaults.

You love getting my payments. You think, "What an easy way to make a living!" So, you start to offer the same kind of policy to lots of other investors. You never expect GE to default. It's free money with no risk. (A broker actually said this, plaintively, to a WSJ reporter.)

CDSs are private contracts. Unlike regulated types of insurance (e.g. homeowners, life), you don't have to hold a minimum amount of capital to back up your promise to me. The government has no control over CDS contracts at all. They aren't listed on any exchange.

Now someone else phones to ask for insurance against the default of GE bonds. They don't own any bonds, but they want to gamble on GE defaulting. You don't care whether they own the bonds they are insuring. They fork over $100, and you insure them for $100,000. It's like buying life insurance on someone else's life.

Since there are no regulations, you can insure as many bonds as you like. You collect the premiums, and take on the liability for the notional value of the bonds that are insured. Billions. Trillions. The notional value of CDSs is said to be $65 trillion. That's 10 times more than the actual bonds.

You like this business. You sell some of your CDSs. You pay for CDSs with other insurers.

Uh, oh. Now there's an economic depression. GE can't pay its notes. It defaults.

Now I phone you. You owe me $100,000. That's what I bought, with my insurance payments.

Everyone else who you insured, for the bonds that defaulted (whether they own the bonds or not) also calls you. You owe a huge amount of money. HUGE!

To scrape up the money, you phone the insurers who now owe YOU money. Unfortunately, they have also sold on some of the CDSs. They don't know who owns the liability now, or even if they are in the U.S. Who owes you the money? They don't know. All the CDS insurers are frantically trying to figure out who owes what to whom.

Total mess.

The only way to even begin to get this under control is to have a transparent exchange (like the stock market, except for CDSs). The SEC has been pressuring the CDS business to set one up for over a year. They are only partly there.

The government can't cancel existing contracts. That's the law. But they can begin to mitigate the problem by restricting CDS insurance only to actual owners of bonds, and only for the par value of the bond. That isn't anywhere near happening.

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