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Isn't much of the $55 trillion dollar market made up of hedge funds and other institutions betting that bonds and other debt products fail?

Name: Ira Bezoza
City & State: East Hampton, New York

Question/Comment: I watched your piece on credit default swaps, which was illuminating but I think missed one point. Isn't much of the $55 trillion dollar market made up of hedge funds and other institutions betting that bonds and other debt products fail? That is, that they really have no insurable interest-they don't own the bond- but are simply making a gambling bet on default?

Paul Solman: It's not clear but it could be true. I tried to suggest that possibility in the piece, without making too much of it, because it's just speculation (in the non-financial sense of the word). ("Now you may have figured out by now that not everyone BUYING these swaps was buying insurance. Lots of investors were just taking a flyer, making a bet that the default risk would rise and their swaps would then be worth more.")

But it's worth pointing out something that WASN'T in the story about the total of $62 trillion (or your $55 trillion, which seems to be the more current number out there): a lot of IT may be double counting. That is, companies like AIG may have "re-insured" their swaps with other companies with further swaps.

Follow? In other words, AIG issues insurance on a $1 billion pool of mortgage-backed securities bonds, then buys a swap from another insurer to "lay off" some of that risk. (That's a term from gambling, when a bookie has taken too many bets on one horse or team or boxer and will go bust if the winners happen to be right.)

But the point is that both the original billion-dollar swap and the subsequent swap to share some of the risk would both be counted as part of the multi-trillion dollar total.

Punchline: the total of $55 trillion dollars worth of swaps represents insurance on less than $55 trillion dollars worth of debt - and maybe a whole LOT less.

-- Posted October 11, 2008 | Comments (0) | Permalink