So, the financial questions keep coming. I’m avoiding a lot of them, because
\n(A) they bore me, and (B) I’m really not the right person to ask. I try to stay
\nout of this stuff unless I have some clue of what I’m talking about. Rest assured, I’m not spending all of my blogging time on this; I’ve got a post on cryptographic modes of operation in progress, which I hope to have time to finish after work this evening.<\/p>\n
But there’s one question that keeps coming in, involving the nature of things
\nlike so-called “Credit Default Swaps”, which I thought I’d explained, but
\napparently my explanation wasn’t particularly clear. So I thought I should fill
\nin that gap, and strengthen the main weakness in my earlier explanations.<\/p>\n
The basic question is: “What’s a credit default swap?”; I think what people
\nreally want to know is both what, specifically, a credit default swap is, and how
\nthe system surrounding credit default swaps and related monstrosities work.<\/p>\n
Credit default swaps are interesting – in the same way that a Rube Goldberg
\ndevice is interesting. They are in a fundamental sense very simple, but the
\nstructure that’s built up around them is so bizarre, so ridiculous on the face of
\nit, that when you look at it in retrospect, it’s hard to believe that anyone
\nactually thought that it was a good idea, or that it could ever work.<\/p>\n
\n A credit default swap is something in between a gambling chit and
\nan insurance policy. To understand that, it’s easiest to start by looking
\nat how these things come about. (The numbers in the explanation are made up, but they’re not unreasonably far afield from reality.)<\/p>\n
Suppose that I’m running the BigNosedGeek pension fund. It’s incredibly
\nimportant that I keep the money in the fund safe. At the same time, it’s important
\nthat I invest the money intelligently, so that the money in the fund grows over
\ntime, to ensure that I’ll be able to pay the benefits that I’ve promised to all
\nthe big-nosed geeks. I’ve got two opposing goals: I want to be safe, and the
\nsafest investments tend to earn very little money; I want to make a decent return
\non the money, but the investments with good returns tend to involve some risk. In
\nfact, that’s deliberate: the reason that risky investments pay more is that they
\nneed to justify their risk – to provide something to the investor to entice them
\nto buy the riskier investment instead of the safe one. In effect, you pay for
\nsafety.<\/p>\n
Now, suppose that this year, BNG pension has a billion dollars to invest. I How can I insure a billion dollar investment in mortgages?<\/p>\n This is where the credit default swaps come in. In a CDS, you pay someone to Everyone’s happy. You’ve invested your $1 billion in mortgages, which will That’s the idea of the credit default swap. Sell the risk of an investment to someone else.<\/p>\n In gambling terms, you can look at the CDS as a bet that the a loan is going A bookie wants to make money no matter what happens. If he’s taking Credit default swaps are a form of bet, and they’re working inside of a The problem with this is that no one is going to take the other down side of First, if you take the bet against the bank, the money that gets bet is yours. Second, if you take the bet against the bank, you don’t have to put up the Looked at in gambling terms, the CDS looks pretty much like a scenario where Just going this far, it should be obvious what can go wrong. What if the But as is all too common in situations like these, it gets a lot worse.<\/p>\n What if you believe that the mortgages are going to go bad, and you want to
\ncan invest it in federal government bonds for a return of 2%\/year. That’s a pretty
\nlousy return for a billion dollar investment. Instead, I decide that I want to
\ninvest in mortgages, which will earn me 8%. That’s much<\/em> better. And
\nhistorically, that’s a a very safe thing! Of course, while it’s reasonably safe,
\nit’s not guaranteed<\/em> to be safe. So I want to protect my investment. I
\nwant to buy insurance to cover my investment – so that if it goes bad, I
\nwon’t lose any of the money that’s supposed to cover retired BNGs.<\/p>\n
\ntake on the risk of the investment failing. You’re swapping the risk of credit
\ndefault with someone, in exchange for a payment. What you basically do is go to a
\nfinancial market, and say “I’ll pay someone 2% per year if they’ll cover my $1
\nbillion investment in mortgages.” If someone takes you up on that, you pay them
\n$20 million per year – and in exchange, they promise to replace your money if the
\ninvestment goes sour.<\/p>\n
\nearn a nice healthy return. Even after paying someone to take on the risk, you’ve
\ndoubled the return on your investment. The guy who took you up on your offer is
\nmaking $20 million per year, for doing nothing<\/em>, so long as the mortgages
\nare good. He’s taking on a risk – he’s going to be on the hook for a lot<\/em>
\nof money if something goes wrong. But he’s getting a lot of money for a minimal
\nrisk. He doesn’t even need to have the $1 billion on hand; he’s just promised to
\npay it if<\/em> something goes wrong. He’s got no money tied up in it – he’s
\njust being paid! Everything is wonderful.<\/p>\n
\nto default. You want to be covered in case<\/em> the loan defaults; so to
\nprotect yourself, you make a high-odds bet against<\/em> your investment.
\nThen if the investment goes bad, the bet pays off.<\/p>\n
\nbets on a boxing match, then he’ll offer odds to different betters in
\na way that producing a balance. Suppose you’re looking at a fight between
\nFreddie the Fighter and Charlie the Challenger. How does a bookie set the odds
\nof the fight of Charlie verses Freddie? He looks at who’s betting which way,
\nand sets up the odds so that no matter who wins, he’ll have enough money to
\npay the people who bet on the winner, with some left over for himself. If
\nthe fighters are very evenly matched, and the bets are running even, then
\nhe’ll give equal odds: bet 1 dollar for charlie, and if you win, you’ll get
\nback an extra dollar. If Charlie is really a hobo who Freddie’s promoter hired
\nto take a fall to extend Freddie’s undefeated record, then the odds are
\ngoing to run very heavily against Charlie: betting for Freddie to beat Charlie
\ncould only pay off $0.001 for each dollar bet, whereas betting $1 for Charlie
\nwould win $1000 if he won. The bookie is going to manage the odds that he’s
\ngiving betters to mantain the balance.<\/p>\n
\nmarket, which acts as a sort of headless bookie. The market effectively sets the
\nodds in a way that strikes a balance. A credit default swap is, basically, a bet
\nthat a particular loan will default. So if I’m bank A, and I’m loaning a billion
\ndollars to bank B, I want to be sure that I’ll get my money back. One way of doing
\nthat is, basically, to place a bet. I bet that bank B is going to default on the
\nloan. Since B is very unlikely to default, the odds on that bet are huge – I can
\nbet one million dollars that they’ll default, and if they do, the bet will pay off
\nall $1 billion.<\/p>\n
\nthe bet. On one side, you’ve got someone who wants insurance against an exceeding
\nunlikely event – so they’re willing to put up some money, effectively betting on a
\nvery unlikely outcome, but with huge payoff odds – things like better $1 million
\nthat a bank will default, expecting to lose the million, but with the proviso that
\nif<\/em> the bank defaults, they’ll get a $1000 to 1 payoff. But on the other
\nside, you’re talking about putting $1 billion to win a paltry $1 million. That
\nmakes no sense at all – no one’s going to put up a billion dollars for a return of
\none tenth of one percent! To try to get around this, the people who set up the
\nmarket sweeten the deal in two ways.<\/p>\n
\nSo if the other guy bets $1 million that the bank will default, you get a million
\ndollars up front.<\/p>\n
\nmoney up front<\/em>. By taking the money bet by the other guy, you’re making a
\ncommitment to pay up if the unlikely event occurs, but you don’t need to pay up
\nfront. So, you get to take the money bet by the other guy, and you don’t need to
\ntie up your own money. Odds are, that’s a damned good deal. You’re getting money
\nfor doing nothing.<\/p>\n
\nyou go to the bookie, and say “I want to bet on the champ defeating the hobo”; and
\nthe bookie just gives you<\/em> the money bet on the hobo winning, and takes
\nhimself out of the picture. If the hobo does win, you’re holding the bag to to pay
\noff everyone who bet on the hobo at huge odds. The bookie didn’t make sure that
\nyou had enough money to pay off the bets if the hobo won. The bookie doesn’t
\nreally care; he’s not losing anything. If the bettor can’t come up with the money,
\nit’s the other bettors who won’t get paid. The bookie is just an agent
\nfor connecting up the betters on the two sides; the question of who’s going to be stuck paying the betters isn’t his problem.<\/p>\n
\ninvestment goes bad, and the guy who took your swaps can’t pay up? There’s no real
\nguarantee here: just an agreement. The guy who took the swaps doesn’t have to
\nprove that he’s got some plausible way to come up with the money! The swaps
\nmarket is private, with no regulation. People in the market trust each other
\nbecause it’s profitable<\/em> (in the short run) to trust each other. But there are no guarantees. All it takes to buy up a collection of CDSs is enough money
\nto buy into the market. Not<\/em> necessarily enough money to pay off the CDSs you buy – no one checks that. All you need is the money to buy a position
\nin the market.<\/p>\n
\nmake money on it?<\/p>\n