CDS and Economics 101
New York Stock Exchange
It’s sad that one of the key components of this downturn goes across the grain of basic, sound economic practices. CDS, or the credit default swap, is a financial instrument created by JPMorgan Chase that allows banks to offset their risks.
Without getting to technical, the premise of the CDS is simple. Banks can sell of the risk of default on a form of credit. Some investor makes payments, and if the credit it is built on defaults, then the bank pays the credit through various means. That’s the very simple explaination of it.
Why would banks do this? To offset their risks. By nature, banks tend to be risk adverse. Yet many of the bad loans out there were risky by nature, so this seems to contradict that. The banks would make these loans because others would be they would go into default. If they don’t default, the bank picks up an extra chunk of change, and if they do, then the extra money helps soften the blow. It’s a risk insurance policy of sorts.
Yet the principle’s behind the CDS don’t make much sense. They were thought to help soften the blow of a default by spreading the risk around. Even Alan Greenspan loved them.
However, just because you somehow make the cost go away for the banks, the cost has to be made up from somewhere. Instead of real cost, we end up having a societal cost involved.
In economics you can have costs that a company doesn’t have to pay, so society picks up the bill. Think about a coal power plant. An additional cost would be the pollution spewing from it, harming plants and animals, and polluting the air. That’s where pollution taxes come from, and make for a good reason for environmental enforcement. This helps shift the cost from society back to the company, who was responsible for it in the first place.
So now lets look at the CDS. Banks could now take riskier positions in regards to who to give credit too and how much. They could then package the risk up in a CDS, and charge an appropriate amount. In their eyes, the risk was now down to that of a more credit-worthy borrower. The problem is, the risk didn’t go away.
Once the banks had shifted the risk burden from bank to society, it was only a matter of time. Without society, banks are worthless, remember that.
I’ll go back into this subject a little bit later. Some of us still have jobs, and I need to head back to mine.
