TOPICS > Economy

Risky Credit Default Swaps Linked to Financial Troubles

October 7, 2008 at 12:00 AM EDT
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Insurer AIG is among the financial titans to hit troubled times in the recent Wall Street crisis. Paul Solman takes an in-depth look at the woes at AIG and explains how credit default swaps played a role its financial turbulence.

PAUL SOLMAN, NewsHour Economics Correspondent: Credit default swaps, these paper contracts turn out to be a key culprit in the current crisis, implicated in the demise of the giant brokerage company Bear Stearns, the giant insurer AIG, and perhaps more giants to come.

As of last year, according to an industry group, there were not $62 million, not $62 billion, but $62 trillion worth of credit default swaps out there. That’s more than four times as much as the GDP of the entire U.S. economy.

But what are these things? In essence, they’re just insurance contracts that pay off in the event of a disaster, a credit default.

But before explaining any further, a brief reminder as to why any of us in the NewsHour community might buy insurance, because, as we’ve learned from childhood, life is full of risks.

A flood or fire could destroy our house, at the very least costing us a fortune. We could have a motor vehicle accident, another pretty penny. A bad fall? And without health insurance, where would we be?


CARTOON CHARACTER: Mr. Magoo, my name is Tire Biter, the fly-by-night insurance company.

PAUL SOLMAN: So we protect against the possibly disastrous tab by paying a small one, buying insurance policies.

In return, the company assumes the risk, by pooling the premiums from lots of people and paying out from the pool in the event of disaster. The insurance company takes a cut for the service. Past history dictates how much they should charge to afford the expected payouts.

Now, because we NewsHour types, audience and correspondents alike, are so prudent and our average age is considerably north of high school, we not only insure, we also save and invest. OK, perhaps not in the risky stocks of our frisky youth.

Age appropriately, we buy a lot of supposedly safer, buttoned-down bonds. So, say for the sake of argument and good footage, that we invest in a successful firm like Hyundai here. We buy its bonds, thereby lending to Hyundai, instead of buying shares of the company.

Offering credit is safer than buying equity, because lenders get their money before shareholders, should the company ever go bust.

So imagine a Hyundai bond for a million dollars pays an annual rate of interest, principal to be paid back in full after a certain number of years. But even this might make us nervous. What if disaster struck Hyundai?

And that’s our cue for the villain of the piece to make its re-entrance: the credit default swap.

We can buy a credit default swap — thanks very much — that would pay us in the event that Hyundai defaults on its bonds. Its credit goes up in smoke. We would have swapped our money for just such a disaster in buying the credit default swap.

And who would have sold it to us? Anyone who might have looked at the solid and successful history of Hyundai and rightly thought, “Default? Ridiculous. Write default insurance and make a quick buck from nervous Nellies like those at the NewsHour.”

Now, I don’t know if there actually were Hyundai credit default swaps. This market is so unregulated no one may know, not even Hyundai, one of the more solid car companies around.

And, in fact, at a hearing on the AIG bailout today, even a former top SEC official admitted…

Regulating credit default swaps

Paul Solman
Financial firms like AIG began to look suspect, spooking their investors, who started selling their stock and calling in their loans, threatening an even greater tidal wave of defaults.

LYNN TURNER, Former Chief Accountant, Securities and Exchange Commission: Does anyone really know what's going on here? The answer is probably no. No one can tell you what's going on here, because there's no place that gathers that data.

PAUL SOLMAN: But there were surely credit default swaps for General Motors and Ford, for those savvy Lehman Brothers, for that high-rolling couple, Fannie Mae and Freddie Mac, even for mortgage-backed securities, whose toxicity we've heard so much about.

Some risk, sure, but would these firms or bonds actually default? Come on. For a good enough price, insure away. And who better to do the insuring than AIG?

In total, AIG wrote some $450 billion worth of credit default swap insurance, covering disasters it was sure would never happen, booking profits on almost every swap it sold, paying the average employee of its swap unit a million dollars a year out of those supposed profits, thereby depleting further the way-too-small pool of assets it would have on hand for claims, were disaster to strike.

CARTOON CHARACTER: This Magoo, is he a good risk?

CARTOON CHARACTER: Don't worry, Chief. That's him.




PAUL SOLMAN: You may have figured out by now that not everyone buying swaps was buying insurance. Lots of investors were simply taking a flier, making relatively small bets on the long shot of disaster and hoping to cash in.

And then, in the past year or so, disaster did begin to strike, resulting in the credit default equivalent of a "Looney Tunes" calamity-fest. Financial firms like AIG began to look suspect, spooking their investors, who started selling their stock and calling in their loans, threatening an even greater tidal wave of defaults.

Confidence was swept away in a heartbeat.

That's what happened to Bear Stearns months ago early in the wave, AIG within the past few weeks, partly because of the mortgage-backed securities on their books, worth far less than they could afford to acknowledge, but also because of their exposure to insurance claims, due to the hundreds of billions of dollars in credit default swaps they've written, often against mortgage defaults, and were therefore liable for.

We end by repeating what may be the most sobering fact of all: $62 trillion worth of credit default swaps out there. And if more companies and bonds default, then more swaps issuers will be on the hook to pay off on debts with money they just don't have.

Or maybe the government takes over, in which case, the bets are on us.