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Credit Default Swaps - Derivatives

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December 21, 2007 – Comments (4) | RELATED TICKERS: CM

My reading list this morning gave a very good write-up on Credit Default Swaps and then a real-life example of what happens when there is a default on these contracts.  It is a fairly long read, but a very good read.  You have to scroll down about half a page to get to the article.

 The article goes over a the ACA Capital example where basically ACA Capital has been down graded from AAA to junk, CCC and now there is the fall out to all the other companies that were using ACA as insurance for their mortgage backed securities.  One company that got hit this week was the Canadian Imperial Bank of Commerce.  I believe they had about $3.7 billion in mortgage backed securities that were insured by ACA and that insurance just defaulted so now CIBC has to realize the current losses on those securities, which was reported in the news this week and was projected to be $2 billion in quarter 1 of 2008.

This is known as a derivative.  Personally, I admit my investment experience with all this kind of stuff was non-existent until the fall of 2006.  I think it was around November of 2006 that I first heard about these things called derivatives and that they were having this rapid and unregulated growth.  The US debt is $9 trillion dollars.  I think last year these derivative things were around $300 trillion dollars.  Seriously, that got my attention big time.  Today derivatives are worth $681 trillion dollars.  The ACA Captial is an example of but one of these derivative things blowing up, and it is a grain of sand on a beach in terms of how many of these things are out there.

As I stated in my last post, we all ought to be able to go about our lives in glorious ignorance of that which we are not involved, however these things will play out in a most undesirable way in all of our lives, most likely hitting our pensions, already hitting our local governments and ultimately our tax structure.

If you consider how excessive credit destroyed the economy in the crash of 29, well, there were lots of people minding their own business, not involved in the excesses of what was happening in the financial and real estate markets and when it came tumbling down, Paul may have been outstanding and stayed away from what he knew was garbage, but Peter was chasing the fools' gold and got caught up in it and then he could not pay Paul what he owed Paul from Paul's legitimate business.  That put a squeeze on Paul so he could pay Fred, who then couldn't pay Sam, and so on, and it destroyed responsible businesses.

What we are already seeing is the Johnsons who were trying to keep up with Jones and got themselves in over their head with debt walking away from that debt.  We have local municipalities, pension funds and other investors being on the hook for that debt as they are the ones that are owed that money.  The rating system said that those mortgages were low risk both because they were asset backed and they were insured.  The insurance model was built on real estate always going up in value.  There will be people hurt in this that owe other people and will not be able to pay.

Certainly as my understanding of what these idiots have done has increased my focus has been how do you best protect yourself from what these morons have done, and to not be the one chasing the fool's gold in a grossly unstable financial system.

4 Comments – Post Your Own

#1) On December 21, 2007 at 10:44 AM, leohaas (32.32) wrote:

The linked article is definitely worth reading completely. Hold on to your hat because this will have significant impact on the financial sector, and likely whole economy. 

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#2) On December 21, 2007 at 11:41 AM, GS751 (27.70) wrote:

liked reading it.  Derivatives are out of control, mainly because of lack of regulation.  WB says derivaties are the weapons of mass destruction of the financial markets.  Know what you are investing in this is how you protect yourself.

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#3) On December 21, 2007 at 1:18 PM, Imperial1964 (97.75) wrote:

Good article.  I'm stealing the link and posting it under my blog from yesterday.

I'm still trying to figure out exactly how much impact this will have on the stock market.  It will cost banks Billions.  But will this force the fire-sale of assets?  More convertible bond offerings at loan-shark rates?  Force banks to cut back lending? 

It will certainly force a re-pricing of risk.  And more rate cuts from the Fed.

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#4) On December 21, 2007 at 10:55 PM, dwot (69.76) wrote:

Leohaas, I think the whole economy as well.  If not from this stuff, from the excess burden of debt.

GS, I think it is going to be very hard to predict where this stuff is going to show up.  I think most businesses will have a higher level of defaults because of this.  

Imerial, I think down for the stock market.  If a business is not directly hit, it will be indirectly hit.

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