I bet $10 on tomorrow's baseball game. The notional value of my bet is about $3 billion.
Should I worry?
No, the notional value of your bet is $10. Where the banks make their money on CDS is where the bookie makes his money. Except the banks get their money up front, which is like paying the booky his slice of the bet each and every month until the event occurs. That is why the banks sell Credit Default Swaps; they dont think that they will ever have to pay out - until they do.
So lets say you have this idea that GM is about to go bankrupt, and you buy a $10 million CDS on GM. This sort of thing is the typical kind of CDS that these Wall Street banks sell. The bank then charges you a monthly fee, say 0.1% of the total notional value which is their exposure if GM does go bankrupt which would be a fee of $10k a month. That sounds like a lot of money, and it is, but if you think that GM is about to go bankrupt and you will make $10 million, it is nothing.
But another difference between the bet with a booky and the CDS with a bank is that the CDS event might not ever happen. you could be paying your $10k for 50 years and never have win-lose event like a ball game that brings the bet to a close. The bank is betting that the game never takes place.
Derivatives market - Wikipedia, the free encyclopedia
Products that are always traded over-the-counter are swaps, forward rate agreements, forward contracts, credit derivatives, accumulators etc. The total notional amount of all the outstanding positions at the end of June 2004 stood at $220 trillion. (source: BIS: [3]). By the end of 2007 this figure had risen to $596 trillion and in 2009 it stood at $615 trillion.
Credit default swap - Wikipedia, the free encyclopedia
By the end of 2007, the outstanding CDS amount was $62.2 trillion,[3] falling to $26.3 trillion by mid-year 2010[4] and reportedly $25.5[5] trillion in early 2012. CDSs are not traded on an exchange and there is no required reporting of transactions to a government agency.[6] During the 2007-2010 financial crisis the lack of transparency in this large market became a concern to regulators as it could pose a systemic risk.[7][8][9][10] In March 2010, the Depository Trust & Clearing Corporation (see Sources of Market Data) announced it would give regulators greater access to its credit default swaps database.
A better analogy is with car insurance. Insurance companies wont let you take an insurance policy out for the family down the street. And for good reason; you have no skin in the game, you have nothing at stake in that families car or its well being. So if I called up State Farm and said that I wanted comprehensive insuracne, put every option in it that they have available, State Farm will say no, they dont live with you.
But that is what is happening with CDS. Suppose I knew the guy down the street is a drunkard who for the last 6 weeks in a row has been driving home drunk as a skunk. So I think that taking out a car insurance policy on him and a life insurance policy would be a good gamble, well so would the car insurance company and they would reject my request.
But not banks, as they are so fucking greedy that they are stupid greedy. They would sell you that car insurance plan in a heart beat, were they running car insurance. They do run CDS, and they will sell you a CDS on GM whether you own any stock in GM or not. Not only that, if you knew I took out a CDS on GM, they would sell you a derivatives contract that says that they will pay you if I collect on the CDS, sort of a CDS on a CDS, but technically not a CDS.
The unregulated derivatives market is full of these kinds of contracts and if the CDS market gets hammered in a massive series of defaults like almost happened in 20008, the whole derivatives market is threatened
BECAUSE THE MAIN BANKS THAT ARE SELLING CDS ALSO SELL ALL THE OTHER CONTRACTS IN THE DERIVATIVES MARKET.
That means if the CDS market goes *poof* the rest of the derivatives market will also go *poof* too. a catastrophic $1,2000 trillion MOTHER OLF ALL POOFS.
We need to regulate the derivatives market. We need to ban CDS unless you hold the equity that the CDS is taken out on. We need to reinstate Glass Steagal.
We need to do this before everything blows up and we are thrown back into the Stone Age.
