| Credit-Default Swap Risk Bomb Is Wired To Explode |
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GoldenOne
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| Credit-Default Swap Risk Bomb Is Wired To Explode |
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October 30, 2011
Source: Bloomberg
The European sovereign debt crisis stands as the latest in a long line of similar crises. Argentina in 2001. Russia in 1998. Mexico in 1994. The list goes back into history. Debt crises are about as natural as earthquakes, but this time there is something different -- and possibly more dangerous.
The European nations are linked in a network of debts, as Bill Marsh recently illustrated in the New York Times with a beautiful piece of graphic art. Greece and Italy are prominent; Ireland, Portugal and Spain lurk ominously nearby. France and Germany seem exposed, too, as does the U.S.
The image is like a complex wiring diagram for a ticking debt bomb. Yet what it shows may be less important than what it leaves out: a largely invisible network of ties among institutions around the world, which could ultimately cause global financial chaos.
This hidden network has been created by institutions that buy and sell unregulated credit-default swaps. These are essentially insurance contracts on bonds; in the event of a default on the bond, the seller of the swap promises to pay the buyer the bond’s value.
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Credit-default swaps are mostly arranged “over-the-counter,” not traded on any exchange or recorded by any central information repository. This explains why Marsh’s map couldn’t show the links they create.
But these undisclosed ties matter a lot. They were the primary reason the U.S. government needed to intervene in 2008 to prevent the collapse of insurance giant American International Group Inc. Ignoring the looming trouble with subprime mortgages, AIG had blithely sold CDS contracts insuring mortgage-backed securities to Goldman Sachs Group Inc., Societe Generale SA, Deutsche Bank AG and other firms. Suddenly, AIG was potentially on the hook for almost half a trillion dollars in payments. Through CDS contracts, AIG’s failure could have spread distress throughout the global financial system.
The AIG case illustrates an important paradox that looms again in today’s European debt crisis. Like regular insurance, credit-default swaps offer a way to spread risks, and standard thinking in economics holds that “risk sharing” of this kind should make individual banks safer, and the entire banking system more stable. It isn’t true, though, at least not always. In fact, too much sharing of risks can actually create bigger problems.
This follows from a recent study by Italian physicist Stefano Battiston and colleagues (one of whom is the Columbia University economist Joseph Stiglitz, winner of the 2001 Nobel Memorial Prize in Economic Sciences). The researchers showed that too much risk sharing can make it easy for distress to spread like a virus.
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Mon Oct 31, 2011 3:22 pm |
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coaster
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| mod's note |
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if you do not have permission to republish that, you are in violation of U.S. copyright laws. Please provide evidence of your permission to republish and also provide proper attribution.
~Tim~
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Tue Nov 01, 2011 6:51 am |
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globaldoc2001
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It seems like this is an interesting stuff, and is something new. I would like to know more, and I hope that this thread gets longer for me to learn things more.
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Tue Nov 01, 2011 8:03 am |
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payment proof
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Interesting post GoldenOne. Next time, you may want to link to the article directly instead of doing a coy/paste. I really hope Europe can work things out.
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Fri Apr 20, 2012 1:46 am |
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