Credit Default Swaps: $60 Trillion of Bullshit

Oct 7th, 2008 | By | Category: Economics

Car insurance makes sense. If I drive or own a car, I better have some way to pay for repairs and healthcare if I fuck up.

And it makes sense that the insurance company better be tightly regulated–forced to keep enough liquid assets around to pay out claims. If the insurance company failed to pay up, it would be a nightmare for everyone.

Credit Default Swaps (CDS) started out as insurance for bonds. For a percent or two of the face value of the bond per annum, you received a contract to pay the face value of a bond if the issuing company defaults. This is little different than life insurance, homeowners insurance or car insurance.

The trouble started in 2000, when the Commodity Futures Modernization Act explicitly banned the regulation of these contracts. Funny things started to happen. People took out CDS contracts on bonds they didn’t hold.

This would be like me insuring your car. Why on earth would I do that? Because if you get in an accident, I get paid. I’m gambling on your failure.

I could be even more clever and eliminate my risk entirely–at least on paper.

Let’s say the government similarly prevented regulation of the car insurance industry. I have $2,000 I want to invest. Your have a bond worth $20,000 at Washington Mutual

I have a good sense that WaMu is going to be in trouble in a bit. But, for now, WaMu is cheap to insure, so I buy a contract insuring your bond at $20,000. Costs me 1%, or $200, a year. It’s a long-term contract set at 10 years, so I’m locked in.

The mortgage market stumbles, and so does WaMu. Huzzah! Now you’re desperate for insurance, and since WaMu is in trouble insuring these bonds is going to cost more. Four percent a year, baby! I quickly sell you a contract: I’ll pay you $20,000 if WaMu defaults (the exact money I’d get if you wreck, since I still have a policy on you), and in the meantime, you’re paying me a whopping $800 a year.

This means I net out $600 a year, and it’s risk free for me. If WaMu defaults, I can pay you the $20,000 from the money I’ll get from my earlier contract, right?

Well, not exactly. What if the guy who sold me that earlier $20,000 policy is doing the same gambit, also leveraging a tiny bit of liquidity he has into a huge contract? And the person he bought a contract from is also doing the same game? And the person after? Horrible cycles can develop, where nobody in the chain really has the money needed to pay off the stack of contracts. All it takes to make these contracts bad is one irresponsible bettor at the bottom who didn’t bother hedging his promise to pay with a CDS of his own and doesn’t have the money to pay his promise.

It all devolves into something like this Beavis and Butthead episode:

This is precisely why the insurance market is tightly regulated. Nobody wants to be insured by the Great Cornholio. Since the credit default swap market wasn’t regulated, this sort of tangled mess grew into existence.

Well, how much money is tangled up in these sorts of “investments,” that did nothing of value, started no new companies, produced no new knowledge or techniques and are glorified get-rich-quick schemes worthy of a sitcom episode?

Sixty trillion dollars.

The entire bond market is about five trillion dollars. This is insane.

Lots of big numbers have been thrown around the past few weeks. But let’s put this one in perspective. The entire economic output of the entire planet was less than $60 trillion in 2007, at about $55 trillion.

2007 was the absolute peak of human endeavor, so far. More human beings were pressed into economic service in a more integrated global economy than ever before. Every single planetary resource was tapped at the maximum, every input stretched to the highest-ever limits. 2007 was the very best that human effort has ever accomplished. $55 trillion dollars of economic might is an astonishing amount of stuff, about $8000 worth for every human being on the planet. Real stuff. Not a line on an electronic spreadsheet or a number in a database. I’m talking surgeries, dental work, televisions, telephones, power lines, meals, airplanes and flights between cities, and on and on and on. This is the sum of our desperate fifty-five trillion dollar struggle to feed those who are hungry and unfed, to clothe those who are cold, to house those who are homeless.

It might be impossible for our government, even the entire collective force of governments worldwide, to untangle this mess of a fake parallel $60 trillion dollars, no matter how much tax money is thrown at it. The entire bailout so far–already unprecedented in scale and aggressiveness–has amounted to something around one trillion of hard-earned, real-world dollars–a drop in a bathtub of woe.

We can’t untangle this mess because so much was leveraged bullshit to start off with. These sorts of cyclical schemes aren’t investing in any true sense of the word. This wasn’t even gambling. It was a means of making numbers in spreadsheet go reliably upwards–increasingly detached from the real world, where making things grow and get better takes effort and risk. So much of the growth of the past few decades has been concentrated in this bullshit, these lies we’ve told ourselves while neglecting the real investments that could’ve made such gains a reality. It’s done.

We cannot resurrect that $60 trillion bullshit dollars tied up in bullshit CDS contracts without making our real $55 trillion dollar world go through a spasm of painful hyperinflation. In a world of $40 gallons of milk, $100 lunches on the Ave and $10,000 a month rents, we probably could conjure the illusory $60 trillion dollars into real existence.

Why should we?