Warren Buffett famously said the following in his 2002 Berkshire Hathaway annual report:

"In my view, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal."

Virtually none of us knew anything about derivatives and Credit Default Swaps in 2002 but, as we face global financial disaster in 2008 we're starting to learn more.

If CDS's are financial weapons of mass destruction who is the "J. Robert Oppenheimer" of CDS's?

The Credit Default Swap was created in 1997 by a then 34 year old British lady named Blythe Masters. She was working for JP Morgan. She and her team developed many of the credit derivatives intended to allow companies to remove risk from their balance sheets. It was a way to separate the risk of a loan from the loan itself. Blythe Masters is currently head of Global Commodities at JP Morgan Chase.

Nobody seems to know exactly how large the totally unregulated market for derivatives has become. The Chairman of the SEC, Christopher Cox, estimated $58 trillion during his congressional testimony last month. That figure numbs the mind!



"Now, I am become Death, the destroyer of worlds." - Hindu scripture, the Bhagavad-Gita

__________________
Bill Wood - Retired Webmaster
My Personal Website
1998 Mercedes E430
2010 Toyota Sequoia
My Photo Albums

The more I look into finance, the more I realize how little I know about it. Credit default swaps? ETFs, etc.

I need to take a Finance course I think. Back to university I go!

__________________
Chris
2007 E550 4Matic - 61,000 Km - Iridium Silver, black leather, Sport package, Premium 2 package
2007 GL450 4Matic - 62,000 Km - Obsidian Black Metallic, black leather, all options
1998 E430 - sold
1989 300E - 333,000 Km - sold
1977 280E - sold
1971 250 - retired

"And a frign hat. They gave me a hat at the annual benefits meeting. I said. how does this benefit me. I dont have anything from the company.. So they gave me a hat." - TheDon

Credit default swaps are like an insurance policy.

For example a bank makes a sub-prime mortgage loan at 6% interest. They can then buy a Credit Default Swap (CDS) from someone like AIG to insure the loan in case the borrower defaults. Let's say they pay AIG 2% for the CDS. The bank essentially has a "risk free" 4% loan. This allows the bank to make more loans.

It's more complicated than that though. Actually, groups of loans are bundled up and sold by the bank to someone else like FannieMae or FreddieMac. The "someone else" buys CDS's to minimize their risk on the group.

You end up with 2 financial instruments...
The group of loans and the CDS's. These instruments look sort of like bonds. They have an interest rate, term, market value, etc. They are called "mortgage backed securities".

Now these 2 instruments can be separated and sold individually. Somebody might buy the group of loans and someone else buys the CDS's. If the original borrowers default then the holder of the loans gets nothing. The holder of the CDS's get's paid (if AIG has the money).

To further complicate things...
The groups of loans can be split as well. They can be split into a financial instrument based on the principle cash flows and another one based on the interest cash flows. Each instrument can be sold to say a bank or pension fund anywhere in the world.

All of this slicing and dicing results in very complicated financial instruments called derivatives. This is the "toxic paper" you hear Treasury Secretary Hank Paulson talking about.

__________________
Bill Wood - Retired Webmaster
My Personal Website
1998 Mercedes E430
2010 Toyota Sequoia
My Photo Albums

The keyword there is "like". Really a CDS IS an insurance policy. No different than the PMI a bank makes (or should have) make you take out if you put down less than 20%.

But by not calling them "Insurance" they skirted the insurance regulators. This allowed companies, like AIG, to sell these to increase their income (read Bonus's) and yet didn't need the capital reserve behind them.

The explanation of the CDS you supplied lays it out pretty good in laymans terms, Webmaster

__________________
KLK, MCSE

1990 500SL

I was always taught to respect my elders.
I don't have to respect too many people anymore.

Its a great explanation, and it makes me believe even more that such transactions should be made illegal. If you can't tolerate the risk that your investment represents, then don't get into it to begin with. These arrangements create a "heads I win, tails you lose" scenario that can't be sustained. The difference between these and PMIs is who pays.

__________________
1985 380SE Blue/Blue - 230,000 miles
2012 Subaru Forester 5-speed
2005 Toyota Sienna
2004 Chrysler Sebring convertible
1999 Toyota Tacoma