{"id":184812,"date":"2012-01-14T20:35:00","date_gmt":"2012-01-15T01:35:00","guid":{"rendered":"https:\/\/www.panix.com\/~msaroff\/40years\/2012\/01\/14\/another-example-why-the-credit-default-swap-is-the-toxic-waste-of-the-financial-world\/"},"modified":"2012-01-14T20:35:00","modified_gmt":"2012-01-15T01:35:00","slug":"another-example-why-the-credit-default-swap-is-the-toxic-waste-of-the-financial-world","status":"publish","type":"post","link":"https:\/\/www.panix.com\/~msaroff\/40years\/2012\/01\/14\/another-example-why-the-credit-default-swap-is-the-toxic-waste-of-the-financial-world\/","title":{"rendered":"Another Example Why the Credit Default Swap is the Toxic Waste of the Financial World"},"content":{"rendered":"

On an article about how Greek government debt may take down the Euro, we find this little gem<\/a>:<\/p>\n

Lagarde\u2019s demand for a larger haircut smacked into an onslaught of leaks from the bond-swap negotiations between the government and private sector bond holders. First, there were rumors that the banks had largely agreed on a deal. Then there were rumors that hedge funds that had acquired some of these bonds at a discount were refusing to go along with anything. They were betting that they could profit from a default because it would trigger CDS payouts. And if the majority agreed to the haircut, they would also profit because Greece would eventually redeem the bonds.<\/p>\n

Now, there are rumors that the government wants to compel these hedge funds to join the bailout majority. Tool: retroactive \u201ccollective-action clauses\u201d\u2014if a majority of bondholders agrees to the deal, the recalcitrant minority could be forced to go along.<\/p><\/blockquote>\n

Of course, the question is how you can make money for this.<\/p>\n

It comes down to the fact that there is something called the “naked” credit default swap.<\/p>\n

The nickel tour is that a CDS is an insurance policy, you pay your premiums, and in the event of “something” happening, you get a payout for the “loss”.<\/p>\n

The reason that I put “loss” in scare quotes is because unlike most forms of insurance, there is no requirement to hold an interest in the continued existence of whatever you are insuring.<\/p>\n

This has been case since 1746 (!) when Parliament passed the Marine Insurance Act<\/a>.<\/p>\n

Basically, if I purchase a CDS on something risky, like Greek sovereign debt, I have to pay a lot of money, but let’s engage in a little mental exercise:<\/p>\n