Derivative hide and seek - Spear's Magazine

Derivative hide and seek

Derivates were dubbed “Weapons of mass financial destruction” by Warren Buffett.

The collapse of Lehman Brothers is beginning to tell us a lot about derivatives, dubbed “Weapons of mass financial destruction” by Warren Buffett, and particularly about the $55,000,000,000,000 – that’s $55 trillion – Credit Default Swap market, which is completely unregulated and non-transparent, meaning no one can tell who is exposed to who or who has lost what.

A CDS is a contract that typically insures a bond against loss from the issuer being unable to repay all or part of the bond. The default insurance on Lehman’s bonds totals $400,000,000,000 – that’s $400 billion – on bonds outstanding of just $150 billion. So the first thing to note is that insurance on $1 of debt was written for $2.67 worth of CDSs.

A settlement auction on Lehman CDSs in the first week of October yielded just 9.75 cents on the dollar, which means that the insurers will have to pay 90.25% or $360 billion – on Tuesday 22 October. What no one knows is how much of this total will be netted off: estimates of what will actually have to be paid out by those on the wrong side of these swaps vary from a few billion dollars to around $250 billion or more, at which level the prospect of other counter-parties defaulting and creating further defaults and losses must be very high.

Of these CDSs, around a third are written by hedge funds, who were buying these CDSs as a short bet on the fate of Lehman. Now many of these CDSs were insured by AIG, currently the recipient of $123 billion of taxpayers’ largesse, who won’t be pleased to find their money going into the pockets of “spivs and speculators”. O, what a tangled web we weave, when we practise CDSs…

Meanwhile, here are two sets of stats to ponder on:

National Debt (excl. pension liabilities and bail-outs) as a percentage of GDP: 

UK Unemployment:
1980 – 2m+
Mid-80s high – 3.2m
1997 – 2m+
Aug 08 – 1.79m
End 09 forecast* – 2.25m
Our view for Q3 09– 3m+

*by John Philpott, Chief Economist CIPD, who now admits this figure is looking too low!