Tuesday, February 19, 2008

Credit default swaps to follow subprime loans, CDOs, to bubbleland stage?

It does indeed seem possible that more and more economic talk will focus on the “arcane” CDSs.

Like other recently crafted financial tools, such as their somewhat kin collateralized debt obligations, or CDOs, CDSs have a few problems. First, what are CDSs?

Credit default swaps were invented by major banks in the mid-1990s as a way to offset risk in their lending or bond portfolios. At the outset, each contract was different, volume in the market was small and participants knew whom they were dealing with.

No. 1 and above all, especially in the eyes of more critical economists, is that CDSs, just like CDOs, are not “marked to market.” In other words, nobody knows if their paper value is at, or even anywhere close to, their real-world value. The reason is the same as with CDOs — they’ve never really been tested on the open market.

Major insurer AIG has already admitted some of its CDSs were mispriced.

Third, one-sixth of CDSs were created as backstops for holders of CDOs, and we know the CDO market ain’t so healthy.