Credit Default Swaps (CDS) are going to wipe out most companies that wrote them due to the cascading effects of a default. Any company that has CDS expose will never be a good speculative investment.
A Credit Default Swap is basically an unregulated insurance policy that any company can write on any financial instrument that someone else wants to reduce their risk on. During the financial boom times (up until early 2008) banks, hedge funds and other companies would sell CDS’s and then buy a CDS on the same security to offset their risk and make money on the spread. This multiple sell/buy is why CDS notional value is $54 Trillion, about 2 times the USA GDP.
A default on a security that a CDS is written on has a geyser like effect: The default flows like water from the security holder to their CDS writer, who passes it on to their writer who does the same. Ultimately, it comes to a CDS that is naked (without CDS or other reinsurance) and the writer has to pay up. As most of these companies were leverage 30 to 1, it is unlikely that they will be able to pay. Just like water that hits the hot bottom of a geyser, this claim shoots back up the system until it finds a financial entity that can pay up. Add enough defaults together and you get something with the predictability of “Old Faithful” that will blow up all the writers which includes many of our major banks.
A CDS default forces banks and other writers to put out more money. In Japan during the 90’s banks were insolvent because the securities behind loans had gone bad and the government simply put off having banks recognize the loss until they could do so without going bankrupt. With CDS’s, writers will need additional capital – banks will get it from the Government but hedge funds, etc. will go bust.
The system will remain frozen due to fears that the deepening recession will cause CDS defaults to happen. Establishing a clearing house for derivatives may not help as it may force an immediate recognition of the liability of CDS’s by banks. Not establishing a derivative market/clearing house is probably worse as the system can’t clear itself without a fair and open market.
Looks like all roads lead to bank nationalization: Do something and it will force recognition that banks are undercapitalized (York University Professor Nouriel Roubini estimate the gap at $2.2 trillion.) Don’t do anything and bank will be forced to keep asking for money as CDS’s are claimed – a lot of money that will ultimately result in the Government owning most of them even if it doesn’t want to.