So let's see if we can get a big picture of everything
that's happening in this credit default swap market.
I'll speak in generalities.
Let's say we have Corporation A, Corporation
B, Corporation C.
And let's say we have a bunch of people who write the credit
default swaps, and I'll call them insurers.
Because that's essentially what a credit default swap is,
it's insurance on debt.
If someone doesn't pay the debt, then the insurance
company will pay it for you.
In exchange, you're essentially giving some of the
interest on the debt.
So let's say we have Insurer 1, let's say we
have Insurer 2.
And some of these were insurance companies, some of
these were banks.
Some of these may have even been hedge funds.
So these are the people who write the credit default
swaps, and then there are the people who would actually buy
the credit default swaps.
In the previous example, I had Pension Fund 1, that was my
pension fund.
Then you could have another pension fund, Pension Fund 2.
Let's re-draw some of the connections between the
organizations.
Let's say Pension Fund 1 were to lend $1 billion to A.
A will pay Pension Fund 1 10%.
But Pension Fund 1 wants to make sure that they'll
definitely get the money, because they can't lend money
to people with anything less than stellar credit ratings.
So they get some insurance from Insurer 1.
So what they do is out of this 10%, they pay them some of the
basis points.
So let's say they pay them 100 basis points.
And in exchange, they get-- I'll call it Insurance On A.
This is this new notation that I'm creating.
They get Insurance On A.
Fair enough.
And the reason why this I1, this first insurer was able to
do that is because Moody's has given them a
very high credit rating.
And so when they insure something, you're essentially
the total package, right?
The loan to this guy, plus the insurance, kind of is like
you're lending the money to this guy, but you're just
getting more insurance-- I mean you're getting more
interest, right?
So this bond becomes a Double A bond.
Because the odds that you are not going to get your money
are not the odds that this guy defaults, but it's now the
odds that this guy defaults.
And Moody's or the standard is poor, as I've already said.
Hey, these guys are good for their money, they're Double A
or whatever.
So now your risk is really a Double A risk and not a Double
B risk, or whatever.
But anyway, this happens.
This is Corporation B, and maybe Pension Fund 2 wants to
lend to Corporation B.
Maybe they lend them $2 billion.
They get, I don't know, they get 12%, maybe Corporation B
is a little bit more dangerous.
But once again, they go to this first insurer.
And maybe they get some of it-- well let's just say they
get Insurance On B.
And B is a little bit riskier, so they have to
pay 200 basis points.
200 basis points goes from Pension Fund 2 to B.
Now this, already, this is a little bit dangerous, right?
Because you can think about what's happening.
One, as long as this insurer does not get a downgrade from
their credit ratings from S&P or Moody's or whoever, they
can just keep it issuing this insurance.
There's no limit for how much insurance they can issue.
There's no law that says, you know what, if you insure a
billion dollars of debt, you have to put a
billion dollars aside.
So that if that debt defaults, you definitely have that
billion dollars there.
Or if you insure 2 billion here, you don't have to put
that 2 billion aside.
What you have is a bunch of people who statistically say,
oh, you know, what's the probability that all of this
debt defaults?
So I just have to keep enough capital so that
probabilistically, whatever debt defaults, I can pay it.
But you don't keep enough capital to pay all of the
defaulting debt.
So you already see an interesting risk forming.
What if all of these corporations, for whatever
reason, do start defaulting simultaneously?
Then all of a sudden this insurance company has to pay
more out in insurance then it might even have. So you have
to wonder whether it even deserves this Double A rating,
because it actually is taking on a lot of risk.
But in the short term, while these companies are-- everyone
is doing well and the economy's doing well, it's a
great business for these guys.
These guys are just collecting premiums essentially on the
insurance, without having to pay out anything.
Now let's add another twist on it.
These pension funds, P1 and P2, it was reasonable for them
to get insurance, because they were giving out these loans
and then they got the insurance.
So they were essentially hedging the default risk by
buying these credit default swaps, which was essentially
just an insurance policy from this Insurer 1.
But you can have another party.
This is no less legitimate, really.
But you could call them-- I don't know-- let's call it
Hedge Fund 1.
And they've done a lot of work, and frankly, they often
are much more sophisticated than the pension fund-- in
fact, they almost always are.
And they say, you know what?
Company B looks really, really, really, really shady.
I think 200 basis points for the chance that Company B
defaults is frankly cheap.
Because I think there's a huge probability
that Company B defaults.
So what I'm going to do, I'm not going to lend Company B
money, because if anything, I think that they're maybe about
to go out of business.
But what I can do is I can buy a credit default swap on
Company B's debt.
Which is, essentially, I'm getting insurance that they
fail without actually lending the money.
So let's say I do that from Insurer 2.
So I can go and I'll pay Insurer 2 200 basis points a
year, or 2% on the notional value of the
insurance I'm getting.
So let's say it's 200 basis points, and let's say that's
Insurance On-- I'm making a big bet-- so they're going to
give me Insurance On B for-- I don't know-- $10 billion.
And something interesting is going on here already.
B might not have even borrowed $10 billion, right?
So all of a sudden you have this hedge fund that is
getting insurance on more debt than B has even
borrowed money on, right?
And it's essentially, you just kind of have this side bet
between these two parties.
This party says, you know what?
I think it's a good deal.
I get 200 basis points on the 10 billion every year, as long
as B doesn't default.
And this guy says, I think B's going to default.
So I think that's a good deal on that insurance.
And just so you understand the math, so the notional value is
$10 billion.
So what's 2% of 10 billion?
2% on a billion is 20 million, so it's $200 million.
200 if I did my math correct.
So they'll pay $200 million a year to this insurer.
So the 200 basis points on 10 billion is
equal to 200 million.
These numbers maybe are a little bit on the big side,
but who knows?
Actually, this could be a huge hedge fund.
This could be a $10 billion hedge fund.
Or even worse, maybe it's a billion dollar hedge fund, or
maybe it's a $20 million hedge fund, but they've taken a $180
million loan to essentially buy this insurance because
they think that B's collapse is imminent.
So they're willing to take that bet right now.
You know, it might be a good bet.
If B collapses tomorrow, what's going to happen?
They only dished out maybe 200 million for maybe that first
year, although you normally pay it on a quarterly basis.
So they'll pay 50 million every three months.
Let's say they pay the first payment, 50 million, right?
And then over the next three months, B just goes bankrupt
and people realize that debt was worth nothing.
Then these guys get $10 billion.
Right?
But something else is interesting here.
They probably did insurance to a lot of other people too,
maybe on B's debt.
Right?
Or maybe they also insured A's debt.
So maybe they gave some insurance on
A's debt, as well.
So what happens?
Let's say B all of a sudden defaults.
So a couple of things happen.
I1 is going to owe P2 $2 billion, right?
I2, the second insurer, is going to owe this hedge fund
$10 billion.
Now let's just assume I2's good for the money.
They have $10 billion they pay to this hedge fund.
This hedge fund is great, they get great bonuses for the year
and they go buy yachts, et cetera.
But this insurer right here, they pay the money they were
good for but something interesting might happen.
All of a sudden Moody's finally wakes up, these
ratings agencies, and says, oh, my God.
Well, there's a couple of things that might make them
say, oh, my God.
First of all, they might say, oh, look.
You have to pay out $10 billion.
And I doubt that was the only person you have to pay, maybe
they have to pay out a lot of money.
Now I2, Insurance Company 2, you are undercapitalized.
I am now going to downgrade your rating.
So, you were Double A, but since you had to give out all
of this capital, Moody's is now going to downgrade you to,
I don't know, B+.
I'm just making these ratings up.
But that's the sound of how these ratings happen, right.
A is better, B is worse.
The more A's you have, the better it is.
But all of a sudden, when this guy is B+, and this guy
insured, let's say, some other corporation's debt for this
pension fund, now all of a sudden this insurance that
this pension fund had is no longer Double A Insurance.
It's now B+ Insurance, and maybe this pension fund, by
its charter, can't hold something that
has a B+ credit rating.
So they're going to have to unwind the transaction, or
maybe they'll have to unload the debt that was insured.
So one, just by Company B defaulting, maybe this guy was
holding some of Company A's debt, and it was insured by
Insurance Company 1.
Now they're going to have to unload that debt.
So just one default creates this chain reaction, right?
This one default happens, this guy has to pay this guy money,
then this guy gets undercapitalized since they
have to pay out money.
Then Moody's says, oh, my God, you're undercapitalized.
We're going to reduce your ratings.
Maybe this guy was insuring some of A's debt, but now
since he was insuring some of A's debt, all of a sudden that
insurance is worth less because it has a lower rating.
And now A's debt, less people want to hold it, because there
are less people to insure it.
I know that's very confusing, but this is really the point
that Warren Buffett was saying when he said that the credit
defaults swap market, or in general, the derivative
market, are financial weapons of mass destruction.
Because you have so many people who didn't have to set
aside a capital, right?
This guy could insure $10 billion worth of debt without
having to set aside $10 billion.
And you have so many people making all of these side bets,
but they're all making two core assumptions.
One, that these rating agencies's ratings are valid.
And two, that the other person is good for the money.
But if all of a sudden you have one failure someplace in
the system, you could have this cascade where one,
there's just a lot of downgrades.
And then a lot of the people end up not being
good for the money.