Credit Default Swaps are a form of gambling used by hedge funds and big banks to pretend that they aren't gambling.
What does this have to do with the US debt ceiling debate thing? Simple. The hedge funds and banks can gamble that the US will 'default' on its debt. If it does, they make a fortune.
Now, who do they place their bet with? Who would take that bet? Who is the bookie?
Well, sometimes it is other hedge funds and banks. Sometimes it is insurance companies. Sometimes it is firefighters pension funds. You never can tell.
Wait, how does that happen? Why would a pension fund be involved in gambling? Or an insurance company?
Sometimes they don't know it's gambling. They don't think it's gambling. The Credit Default Swap gets packaged, repackaged, and re-repackaged into a bunch of other "products". Sort of like if you took the byproduct of an industrial process, like say, the chemical melamine, and put it into cows feed because hay was too expensive, and then you sold the cows milk on to a milk factory, which might even make powdered baby formula. Now imagine the people in charge of rating baby formula, like the food inspection agency, are complicit with all of this. This is what happened in China a few years ago, creating the 'Kidney Stone Babies'. The melamine was put into baby milk, sort of like the Credit Default Swap is put into the Synthetic Collateralized Debt Obligation.
Of course, the Synthetic CDO is mostly gone now after the 2008 crash. Nobody wants them anymore. But Credit Default Swaps probably have found new places to hide. Where are they hiding? On the balance sheets of 'legitimate' companies? In structured investment vehicles? In the belly of some other insurance company, perhaps a re-insurance company owned by various hedge funds, since re-insurance companies are not regulated like insurance companies are? Who knows. The entire Credit Default Swap market itself is still secret and unregulated. The only thing you need to do to have a CDS contract is two organizations agreeing to be 'counterparties' to each other, and it only requires a handful of people within those organizations to do it.
But CDS are not always repackaged or hidden when people 'take the other side' of the bet. Insurance companies like AIG, MBIA, AMBAC, and other sold tons of the stuff, because they could get what they thought were "riskless profits" from selling them. In fact, Credit Default Swaps are sometimes described and/or advertised as a type of insurance. Every quarter of the year, big fat "insurance premium" checks would come in from the CDS gamblers. But it is not the first time the concept of insurance and gambling have been linked; in the 1800s there was a game called 'policy', in which you bought an 'insurance policy' that certain public lottery numbers might be chosen by the people in charge of the lottery. The attraction was to people who could not afford real lottery tickets. If the lottery numbers were "21, 12, 14", and you had bought a policy that "14" would be in the numbers, then you won. Of course Policy turned out to be a massive racket, rigged and run by organized crime figures, but it was quite popular until it's banning around the turn of the last century. It eventually was reborn as 'the numbers game' in the early 20th century.
But a Credit Default Swap is not like an ordinary gamble. Consider if you bet at a horse-racing track: you only get payed when the race is over. With a CDS, you can get payed based on how the race is going, while its going on. Say you bet that a horse named Susie would lose. If the race goes halfway through, and Suzie is not doing very well, then you could get payed. Not only that, image you can place bets while the horse race is ongoing. If you bet for a certain horse to win, but you see it losing halfway through, you could also bet against it, or bet for other horses. In fact, you can do this right up until the finish line - as long as you can find someone to take the other side of your bet.
The more uncertain the finality of the race, the more people want to change bets. Imagine if you had bet that the greatest horse in the world would lose the race. Everyone else has bet the horse will win. Halfway through the race, this greatest horse is stumbling, and her rider has half-fallen off, and she is at the back of the pack. Suddenly, everyone wants to change their bets. They want to bet the same way you did. In fact, they want to buy your betting tickets from you!
Now. Imagine that you are not betting on horses. Imagine you are betting on a 'default' of some 'debt'. Like, say, the US Government debt. The greatest horse in the world, that very few people bet to lose. The more debate there is about whether or not the US will 'default' on it's debt, the more people start to buy Credit Default Swaps on it. What happens when a bunch of people try to buy a product that has a limited supply? The price goes up. What happens when you own a product whose price is skyrocketing? You can sell it and make a fortune.
Thus. Let's say you had bought Credit Default Swaps against US Debt back in, say, 2006. Lets say you bought them for one million dollars. The real terminology used is a little bit different. It, in fact, is sort of like the old Policy scam terminology from the 1800s. You "buy insurance" against a certain amount of US debt going into default. The parties can call it insurance but it is really gambling. You don't own 1 billion dollars of US debt, you don't know anyone who does. You just want to get payed-off if it defaults. If the "insurance" you buy costs 1 million against 1 billion, that is one tenth of one percent, or ten "basis points".
Now, let's say it is 2011. The US Congress all of a sudden decides it doesn't want to raise the debt ceiling this year, even though it has done it for years and years going back decades. Suddenly, there is a question of the US debt going into default. The greatest horse in the world might lose! Now, everyone wants to buy Credit Default Swaps against US Debt. What happens? The price goes up! Back in 2006, it only cost you 1 million dollars to "insure" 1 billion dollars worth of debt. Now, in 2011, it might cost 4 million dollars to insure that same amount!
Now, where will people buy the Credit Default Swaps from? You! Why not? You own a pile of them - you bought them for 1 million dollars, and now you can sell for 4 million! That's 3 million dollars of profit in 6 years, and you didn't have to lift a finger. You just had to be willing to be risky and gamble back in 2006.
Now, why would you sell out now? Why not wait until the US really defaults? Couldn't you make a lot more money in that case? Wouldnt', in fact, your "counterparties" have to pay you back a full one billion dollars in the case of default? Wouldn't that be a massive profit? Sure. But what if the US doesn't default? What if the Congress and the President reach agreement? Then nobody wants Default Swaps against US debt anymore, and the price falls to almost nothing, and you cannot sell it for a big profit anymore. You watch your 3 million paper-profit disappear overnight. But what if the US does default? The whole system might collapse. Your counterparties might not even exist - they might be instantly bankrupt. If they are mysterious hedge funds, they might disappear to an Island somewhere. Then, you might have 3 million paper-profits, but the people who were supposed to pay you don't have any money, or don't even exist anymore. Who knows what will happen?
And so you find yourself in a situation, just like the people on the game shows on TV, or the average person in a Casino. Do you want to take your winnings and go home? Or do you want to risk it all, to make a much larger sum of money?
I forgot to mention; people who buy 1 million dollars of Credit Default Swaps often aren't doing it on their own. They might be, themselves, hedge fund managers or bank derivatives traders, who are not only trading their own money, but other peoples money. Thus, they are constantly being pestered by clients and investors for higher profits, and for news about what is happening. Now, they are not only deciding on whether to risk their own money for huge potential profits , but the money of their clients, bosses, and associates too.
This boil of emotions is occuring right now, all over the world, in the stomachs of financial folks. When Credit Default Swap traders read the stories about the US Congress and the President and the political parties debating the debt ceiling and the default, they are not thinking about unemployment, or about the future cost of US government borrowing, or about interest rates, or about education, healthcare, defense, politics, etc. Some of them are thinking about whether to take their winnings and go home, or to wait it out and see if they can make even more massive amounts of money. Others are wondering if it's too late to get into the game. Others, those who bet that the US would never default, are scrambling to find counterparties to buy CDS from.
Stories like this one:
ABC News, By ALAN FARNHAM,
claim the CDS market is about 'investments' and 'insurance' and 'hedging'. Those are misleading euphemisms. The CDS market is about gambling.
Sometimes, I am glad I'm not rich.