the mechanics of credit default swaps Credit Default Swaps are an over-the-counter financial instrument used by participants in the fixed-income space to both hedge against & speculate on the risk of a company defaulting on its debt (hereafter referred to as the Reference Entity, or RE). Each CDS transaction involves two players - a "buyer" of protection on the RE, and the guy on the other side of the trade, the "seller" of protection on the RE. Essentially, the buyer of protection is "short" the creditworthiness of the RE - he is betting that the RE will default on its debt, and the seller of protection is "long" the creditworthiness of the RE - he is betting that for the duration of the CDS contract (typically 5 years), the RE will not default on its debt. Credit Default Swaps are typically purchased in blocks of 10 million dollars - that is, a buyer of protection is buying insurance against 10 million dollars' worth of an RE's debt defaulting. Per the terms of the contract between the buyer and seller of protection, the buyer will periodically (typically yearly) remit a payment for the protection to the seller of protection. This amount is typically notated in basis points, or "bps". Think of each basis point as representing 1/100th of a percent of 10 million dollars - so a CDS contract that costs the buyer of protection "100 bps" results in the buyer of protection remitting 100,000 dollars yearly to the seller of protection. The seller of protection receives these payments in exchange for his guarantee to remit, in the case of a default by the RE, the notional value of the CDS (10 million dollars) minus the eventual recovery rate on the defaulted debt (on the Street, it is generally assumed to be about a 40% recovery rate, meaning that contracts, when an RE actually defaults, pay out about 6 million dollars per 10 million notional to the buyer of protection). Now here is where things get tricky - what if I have bought protection from you, and when the RE defaults, you are unable to pay me? And what if shortly after I bought protection from you, the price of protection rose (lets say due to a negative earnings warning), and I sold protection to someone else, expecting my selling of protection to be fully hedged by my original purchase of protection? This is what Greenspan refers to as cascading-cross defaults - the fact that if one party in this chain of parties (and you can multiply the example I just gave by thousands of interconnected counterparties)defaults, the results can be catastrophic across the space. After all, I was relying on you paying me in order to pay the other guy, who was in turn depending on me to pay him to pay the OTHER guy...you get the picture. Something like this happening would be terribly destabilizing for the financial system, but its first-order effects are not what would hurt the average citizen - instead, it would be the complete seize-up in the financial markets (think the mortgage business in Florida today, but several orders of magnitude worse) resulting from such a situation that would hurt the average joe. ------------------------------------------------------------------ Synthetic CDOs. Imagine yourself a magic box. A box with infinite possibilities. A box in which one may place - say - credit risk. Imagine this thing - this "credit risk." What is credit risk? How does one "get" credit risk? From where? Why, there are two ways - either by purchasing actual bonds (cash bonds), or by writing credit default swaps (selling protection, see previous posts for more details). Now you are a lazy lazy magical box owner. How can your lazy self stuff your magical box with credit risk in the easiest way possible? Cash bonds are hard to find - sometimes quite illiquid - and you can never get the right size! You think to yourself...hmmm....why don't I just write a bunch of protection? Its credit risk, right? Yeah! Why don't I write a billion dollars of protection?! On 100 different companies, for 10 million dollars each! Brilliant! I can fill my magical box to the brim with the stroke of a pen! Now this magic box has 1 billion dollars in notional credit risk - and you're receiving several hundred basis points a year on 1 billion dollars in protection that you wrote! You're a genius! But wait...that's just too easy...you don't want ALL the credit risk, just the really, really, really risky stuff. Cause that's how you make money baby! Risk-reward! So what do you do? Well...you take the magic box, and next to it, you create a CAPITAL STRUCTURE. And what's in this capital structure? Well, there's a really good TRANCHE up top, and these guys at this place down the block called Moody's say its AAA. Triple-A! Like the U.S. Government! Oh boy, you say, but its just a bunch of credit risk! And Moody's tells you, no sir, you've SLICED and DICED, and if you SLICE some more, you can make ANYTHING YOU WANT! And you say to the Moody's guy: I WANT THE RISKIEST RISKIEST MOST RISKY PIECE! SLICE ME ONE! And the Moody's guy says to you: Well - take this slice off of the VERY BOTTOM - we call it the EQUITY TRANCHE - but don't forget, its RISKY! If somebody defaults, you lose a lot of money! And you say your thanks to the Moody's guy, because you’re a gung-ho RISK-TAKER, and you go on your way. Now everything has been humming along – the magic box is stuffed to the brim, the capital structure has been made, and you, the genius who created it, sold off all of the pieces of the structure to various investors. Now, since you’re such a risk taker, you decide – hey! Why don’t I take a bunch of everyone else’s riskiest pieces, and make ANOTHER capital structure, and slice it and dice it and get the Moody’s guy to tell me one piece is AAA and another is BBB and before you know it – you’ve created a synthetic CDO of a synthetic CDO. Okay, maybe that was a terrible story to give you all an idea of what a synthetic CDO is. A synthetic CDO is just like a regular ol’ normal CDO, except for instead of cash bonds being used as the collateral (CDO = Collateralized Debt Obligation), synthetics (CDS) are used to mirror the credit risk of cash bonds. The synthetic CDO will sell protection, and receive premium, on a variety of bonds – and then a capital structure is created off of the CDO, with the cashflows from the sale of protection allocated pro-rata, and the losses from defaults allocated from the bottom up (i.e., the owner of the lowest tranche of the synthetic CDO has to pay in cash when the first defaults occur, and then the next lowest pays, and so on so forth all the way up the capital structure). Here is the problem with synthetic CDOs – they are extremely hard to value. Not only must you factor in the cashflows that you are receiving from your original sales of protection (which were sold at levels far too cheap in my opinion given the current state of the credit markets and the state of the credit markets when most of these monsters were created), but you must also factor in recovery rates in the case of default, and the possibility that the highest tranche (the AAA tranche) may actually have to PAY OUT. This is absolutely NOT SUPPOSED TO HAPPEN – the AAA tranche is supposed to be a AAA – i.e. damn near zero risk of defaults ever touching it. http://siliconinvestor.advfn.com/readmsg.aspx?msgid=24818876