Shenanigans
I don’t usually blog on finance or economics, but this tale is too good to pass up. James Hamilton on some recent CDS shenanigans:
A credit default swap is sometimes described as an insurance contract written against the possibility of default of a particular underlying asset. If I buy a CDS and the specified asset defaults, I get to collect money from whoever sold me the contract. If I also have a long position in the asset in question, I might consider buying a CDS written against that asset as an insurance or hedge against the possibility that the asset loses its value.
But I don’t actually have to own the asset in question in order to buy a CDS from somebody else. I might want to buy a CDS as a partial hedge against some other asset I hold with which the specified security could be correlated. Or maybe I just feel like making a bet with somebody I think is dumber than I am.
The fun and games begin when multiple contracts get written on a single credit event and the notional value of outstanding contracts on that event– the total amount of money that is promised to be paid to the buyers of those CDS in the event of a default on the underlying asset– becomes larger than the par value of the underlying asset itself. Then it would clearly pay the party who sold those contracts to buy the underlying asset itself at par, relieve the original debtors of their burdensome obligations, and be out only $X (the underlying event) rather than some multiple of $X (all the contracts written on the event).
Amherst Holdings, a little firm from Austin Texas, did just that. They sold $130 million of CDS contracts to big banks against the default of some $29 million of subprime loans in California, and proceeded to pocket the difference.
Had the people buying those CDS contracts actually been using them as insurance, they’d be completely happy to see those subprime loans not default. In actuality, the big banks were just making a bet with someone whom they thought was dumber than themselves. And that can be a dangerous way to gamble.
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