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  1. Wealth
October 27, 2008

Derivative hide and seek

By Spear's

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+

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

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