Thanks, Skeeter, I get all that. I would pick one nit with the idea that CDS exposure represents multiple claims to an underlying asset.
Let's say your house is worth 200k. Neighbor A pays a small premium to neighbor B for the right to collect 200k from B in the unlikely event your house burns down. Neighbor B now has the premium in pocket, but he may not have the funds to pay the 200k if your house actually burns. Neighbor B then takes out a similar bet by paying a premium to neighbor C, who is now obligated to pay 200k to B if the house burns.
Neighbors D and E and F and G and so on all enter into similar transactions. The only money changing hands is the small premiums, but the "notational" value of all these bets is 200k times how ever many transactions there are. Let's say a hundred bets like this has been made, so the notational value of the bets on your house is $20,000,000. Big scary amount relative to the value of the asset.
Then against all odds, your house actually burns. Some of the neighbors who have collected premiums have the means to pay the 200k to their counterparties, and they do. If everyone who made these bets had the capital to pay when your house burns, a total of $20,000,000 would just shuffle back and forth between hands, without causing any real problems. But many who made the bets can't pay. They'll have to scramble to sell whatever assets they have to make partial payments, and maybe they go broke.
None of this betting is productive and it would be better if it didn't happen. But it could be regulated in a reasonable way if all these bets were made on a transparent exchange, and no one was allowed to make such a bet unless they could prove they had sufficient capital to pay.
None of these bets represent claims to ownership of the underlying asset, your house. They're just side bets on what happens to the asset. But the burning of your house will probably result in a domino effect of liquidating assets by the bettors who were undercapitalized relative to the bets they made.
As you know, that's part of what happened in late 2008. Hedge funds had to liquidate assets to meet margin calls on their CDS exposures. That's part of what the Fed is trying to avoid with its liquidity pumps and shoring up of asset prices. Stoneleigh expects another forced liquidation event in the next year or two no matter what. I don't disagree with her because this stuff is still completely out of control. |
