Trouble understanding Credit Default Swaps?

[telcoman]

It is explained here thanks to The New York Times.

http://www.nytimes.com/2008/09...8Oj1g

It is a long read but here is a portion

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"Morgan proposed the following: A.I.G. should try writing insurance on packages of debt known as “collateralized debt obligations.” C.D.O.’s. were pools of loans sliced into tranches and sold to investors based on the credit quality of the underlying securities.

The proposal meant that the London unit was essentially agreeing to provide insurance to financial institutions holding C.D.O.’s and other debts in case they defaulted — in much the same way some homeowners are required to buy mortgage insurance to protect lenders in case the borrowers cannot pay back their loans.

Under the terms of the insurance derivatives that the London unit underwrote, customers paid a premium to insure their debt for a period of time, usually four or five years, according to the company. Many European banks, for instance, paid A.I.G. to insure bonds that they held in their portfolios.

Because the underlying debt securities — mostly corporate issues and a smattering of mortgage securities — carried blue-chip ratings, A.I.G. Financial Products was happy to book income in exchange for providing insurance. After all, Mr. Cassano and his colleagues apparently assumed, they would never have to pay any claims.

Since A.I.G. itself was a highly rated company, it did not have to post collateral on the insurance it wrote, analysts said. That made the contracts all the more profitable.

These insurance products were known as “credit default swaps,” or C.D.S.’s in Wall Street argot, and the London unit used them to turn itself into a cash register.

The unit’s revenue rose to $3.26 billion in 2005 from $737 million in 1999. Operating income at the unit also grew, rising to 17.5 percent of A.I.G.’s overall operating income in 2005, compared with 4.2 percent in 1999.

Profit margins on the business were enormous. In 2002, operating income was 44 percent of revenue; in 2005, it reached 83 percent.

Mr. Cassano and his colleagues minted tidy fortunes during these high-cotton years. Since 2001, compensation at the small unit ranged from $423 million to $616 million each year, according to corporate filings. That meant that on average each person in the unit made more than $1 million a year.

In fact, compensation expenses took a large percentage of the unit’s revenue. In lean years it was 33 percent; in fatter ones 46 percent. Over all, A.I.G. Financial Products paid its employees $3.56 billion during the last seven years.

The London unit’s reach was also vast. While clients and counterparties remain closely guarded secrets in the derivatives trade, Mr. Cassano talked publicly about how proud he was of his customer list.

At the 2007 conference he noted that his company worked with a “global swath” of top-notch entities that included “banks and investment banks, pension funds, endowments, foundations, insurance companies, hedge funds, money managers, high-net-worth individuals, municipalities and sovereigns and supranationals.”

Of course, as this intricate skein expanded over the years, it meant that the participants were linked to one another by contracts that existed for the most part inside the financial world’s version of a black box.

Goldman Sachs was a member of A.I.G.’s derivatives club, according to people familiar with the operation. It was a customer of A.I.G.’s credit insurance and also acted as an intermediary for trades between A.I.G. and its other clients."

----------------------------------------------------------------------------------------With no regulation, oversight and little or no understanding of this business by anyone outside this business, this article explains how we got into this mess.

I am Telcoman and I approve this article.

Telcoman

Modified by telcoman at 5:27 AM 9/28/2008
Modified by telcoman at 5:30 AM 9/28/2008

[Cold_Zero]

I fail to see, other than AIG doing a bad job of assessing their risk in the market, what AIG was doing is any different than, Insurance Companies ensuring people in the Gulf Coast/Southeast Costal region. They are taking a risk that another hurricane like Ike, Katrina and Andrew won't blow through and destroy everything in sight, or Insurance companies insuring the World Trade Center buildings against disaster. Unfortunately hindsight is always 20/20 and history proves that these were bad investments. But investment is never without risk. I guess my question to you or the NY Time is what did AIG do that is different from what these other insurance companies (listed above) did? It appears in our society when you insure something and there is a cataclysmic event, the Government typically steps in to help out.Bud

[telcoman]

I fail to see, other than AIG doing a bad job of assessing their risk in the market, what AIG was doing is any different than, Insurance Companies ensuring people in the Gulf Coast/Southeast Costal region.

I guess my question to you or the NY Time is what did AIG do that is different from what these other insurance companies (listed above) did? It appears in our society when you insure something and there is a cataclysmic event, the Government typically steps in to help out.Bud

What AIG did was not having reserves set aside to deal with a cataclysmic event.

The wall street firms should be assuming more of the risk with this bailout than the taxpayers.

Telcoman

[Cold_Zero]

No insurer has assets to back every piece of insurance if something cataclysmic were to happen. They play the odd, just like bookies betting that you won't need to file a claim.bud