CDS = credit default swap which is a fancy way of saying you pay a premium and in the event of a default, you get a big check. and that is fancy way of saying you're basically buying a life insurance policy so, in the event of death you get paid.
people bought lots of CDS on Lehman Brothers. when Lehman failed, the owners of the CDS got huge checks, written by the writers of that CDS (in many cases AIG).
you can buy CDS on anything these days. one popular thing to buy is CDS on sovereign nations.
typically, CDS agreements have an annual payment schedule and are good for 5 years. In the case of the United States, the CDS trades at 100 bps, roughly meaning you would have to pay 1.00% of the insured amount each year for 5 years. if at any point during those 5 years, the US defaults on its loan obligations (ie, goes bankrupt), you would get paid the insured amount. so if you wanted $100 insurance on the US government, you would pay $1 each year for 5 years. If the US defaults during that time, you would be paid $100. approximately, this suggests that there is a 5% chance that the US defaults in the next 5 years.
in the case of Icelandic CDS, the rate is 1000 bps so you have to pay $10 each year for 5 years and if Iceland defaults, you would get $100. so the market suggests that there is a 50% chance of Iceland defaulting.
if you can buy insurance for anything and for any duration, why not buy insurance against a catastrophic event? now this is super grim, but, what do you think the CDS would trade at for protection against an atomic event happening in manhattan? ie, in the next 50 years, what is the chance that some sort of atomic detonation occurs in new york?
makes me want to move to a city that is already a wasteland, like LA.
Don't you mean move BACK to LA?? How quickly you've forgotten about your rock star days in Los Angeles - if I remember correctly, you enjoyed them quite a bit. Shame on you, my friend, shame on you.
ReplyDeletesorry, i Rebecca is right. i meant, move BACK to the wasteland.
ReplyDeleteCDS pays out in the event of a default of a reference security. there is no security that defaults in the event nyc gets nuked. maybe you can make an arguement nyc muni or MTA bonds default...of course...the MTA and NYC have a littany of other financial issues ahead of a catastrophic event. curious where nys or nyc muni cds trades...
ReplyDeleteyou make a good point. but it only highlights why CDS can be so bad - because you don't have to own the underlying security to get cds. but in this case, you could easily create a synthetic security to be the underlying - like a bond that continues to pay a coupon as long as NYC doesn't get nuked. so, if you have a problem with the CDS part, what would the coupon have to be on a bond paying out as long as NYC doesn't get nuked? i think it would be high.
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