Thursday, 2 October 2008

Going, Going, Gone!

Another extract from Robert Peston's blog on the BBC website:

And now for the complicated and scary stuff. Today is the beginning of "auction season", when the International Swaps and Derivatives Association starts a series of auctions to settle who pays what to whom on a plethora of credit derivative contracts relating to businesses that have gone into default.

It's settlement time on those humungous insurance policies for corporate debt, called credit default swaps. [...]

In the coming three weeks, payouts of hundreds of billions of dollars may be made - or at least demanded - to cover losses arising from the defaults on the debt of Fannie Mae, Freddie Mac, Lehman and Washington Mutual. [...]

Now the problem here is that for every beneficiary of these payments, there's an underwriter - those who provided the CDS insurance - which has to find the cash.

I'm sure that there is no need to worry about the fact that this was a largely unregulated market.

Regulators just get in the way, with their fussing around, needlessly checking up on trivial things like: "Has the underwriter actually got enough money to pay out on all the claims that may be made upon it?"

And if those companies should find out that their insurance policies are worthless, well, it's not the end of the world.

Indeed, the really clever ones will not only have an insurance policy to protect them from their customers defaulting on their debts, they will have another insurance policy to compensate them in the unlikely event that their first insurance policy proves to be worthless.

And the really, REALLY clever ones will have yet another insurance policy to protect them from the even more unlikely event that THAT insurance policy should fail.

And so on. And on.

So the chances of actually having to pay out on THOSE insurance policies are so incredibly remote, it makes perfect sense to take on as much of that business as you can, because you will never have to pay out on it. There's no need to have any capital in reserve, because it will never be needed. You could, instead, pay it as bonuses to your executives. It's a licence to make money. People just pay you to do nothing.

Of course, you are in trouble if there IS a claim, because you can't pay it - which means that the next company won't be able to pay out on their (bigger) claim, which means that the next company won't be able to pay out on their (even bigger) claim.

And so on. And on.

Which means that a lot of companies might find out they have got less money than they think they have.

But that's ok.

They should be getting used to that by now.

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