[ArtWilliams]

The whole swap market can be used as either a bet or a hedge (to reduce risk). Here is an example:

Bank A has one loan and one deposit to simplify things. The loan (asset) matures in 5 years. The deposit (liability) matures in 1 year. Bank A would like to better match the two so it can lock in its spread (income from loan - amount paid to depositor). It goes out to the swap market and finds another Bank (Bank B). Bank B also has one loan and one deposit to simplify things. The loan (asset) matures in 2 years. The deposit (liability) matures in 5 years. The two banks create a contract on paper to swap their deposits. This is an off balance sheet or contingent item with only the net difference ever being paid out. The customers holding the deposits never know and get their money from the Banks where they deposited their money.

As a result of the swap, Bank A has achieved the goal of matching the terms of its assets and liabilities and locked in its spread. The act of doing this, however, creates counterparty risk because the swap party (Bank B) has to follow through on his contract (with Bank A). Swaps can be used for many, many types of transactions (interest rates, foreign exchange, lengths of contracts, etc.). They are not risky unless they are done naked (also called unhedged).

The real fear here is, with trillions of dollars of contingent liabilities, there is no way of knowing what will happen if large sums of them default.

Originally Posted by Bill

People said that?

Bwah-hah-hah-hah-choke-sputter-cough.

But you're right, thats a whole nuther discussion.

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I thought what Ben Stein said about credit default swaps being the real problem, the HUGE problem hidden behind the mortgage bailout, is relevant.

http://finance.yahoo.com/expert/article/yourlife/109609

"Here s one big part of the answer. First, the alert reader will notice that Ben Stein said many times that the amount of money at risk in the subprime meltdown was just not enough to sink an economy of this size. And I was right...to a point. The amount of subprime that defaulted was at most - after recovery in liquidation - about $250 billion. A huge sum but not enough to torpedo the US economy.

The crisis occurred (to greatly oversimplify) because the financial system allowed entities to place bets on whether or not those mortgages would ever be paid. You didn't have to own a mortgage to make the bets. These bets, called Credit Default Swaps, are complex. But in a nutshell, they allow someone to profit immensely - staggeringly - if large numbers of subprime mortgages are not paid off and go into default.

The profit can be wildly out of proportion to the real amount of defaults, because speculators can push down the price of instruments tied to the subprime mortgages far beyond what the real rates of loss have been. As I said, the profits here can be beyond imagining. (In fact, they can be so large that one might well wonder if the whole subprime fiasco was not set up just to allow speculators to profit wildly on its collapse...)

These Credit Default Swaps have been written (as insurance is written) as private contracts. There is nil government regulation of them. Who writes these policies? Banks. Investment banks. Insurance companies. They now owe the buyers of these Credit Default Swaps on junk mortgage debt trillions of dollars. It is this liability that is the bottomless pit of liability for the financial institutions of America."

There are as much as $60 trillion (with a T) at stake in the totally unregulated CDS market - and those "bets" have to be paid by somebody, and nobody realy knows how many of those bets have become due.

The point is, we are deep in uncharted territory. Our economy stopped being about productivity, and has become "virtual" - based on financial manipulations nobody really understands.

Ben Stein ends with this....

"As I said, the pit of loss is bottomless. Warren Buffett, the smartest man of all time in the world of finance, has called financial derivatives - of which Credit Default Swaps are a prime example - "weapons of financial mass destruction." And so they are. As with the hydrogen bomb, no one thought they would ever be used to end the world. But unless someone figures a way out - and maybe the new RTC is and maybe it isn't - we are in real peril. This should never have happened. Now that it did happen, should the taxpayer pay to make the billionaire speculators whole on their bets? What the heck is to be done?"