Think of the world of security derivatives as a giant bookie ring, where anybody can bet on any thing. Specifically, you could bet that Lehman Brothers would default on certain of their bonds within some six month period, even if you don’t own any. And I could accept that bet, i.e., I could "sell you that credit-default swap" (CDS), even if I don’t have a prayer of covering all of the Lehman swaps that I’ve sold already — this insurance/gambling is unregulated, so as not to fetter the miracle of the free market with government intervention.
On our planet, which I’ve read has $60T, there are $50T worth of credit-default sawap, most of them owned and/or sold by financial institutions. (Here B means Billion and T means Trillion, which is 1000B.)
Now, for perspective:
— there are only $11T in mortgages on U.S. real estate, of which only one percent ($110B) are in default.
— the USA’s annual GDP is $15T.
— the USA’s national debt is $10T on which it pays almost $500B in annual interest, and which has been growing at the rate of $600B per year under GWB.
— the USA imports $700B of petroleum annually.
— the USA spend $150B per year to occupy Iraq.
I conjecture that those CDSs and the uncertainty about the need to pay them off and ability to collect on them that is paralyzing the credit industry, for two reasons:
— Nobody knows how much liquidity they need to cover the CDSs they’ve sold.
— Nobody knows the likelihood of a potential borrower need to cover CDSs they’ve sold and/or to collect on their current or potential CDS claims, i.e., nobody knows how to evaluate the books of institutions that have bought and/or sold a substantial volume of CDSs. (For example, at Friday’s bankruptcy auction, Lehman bonds went for 9.75 cents on the dollar, so those who sold CDSs against them will have to pay out the other 90.25 cents to the tune of roughly $400B.)
Therefore, I agree with bernhard at http://www.moonofalabama.org/2008/10/financial-mar-1.html
A really decisive move over the weekend would be to Declare All Credit Default Swaps Null And Void. That would solve 80% of the problems the banks have right now. Some would still fail, but with the big issue removed, interbank lending and commercial lending would carry less risk and revive.
IMHO, banks can’t afford to loan now, in part, because they have no idea what reserves they need to cover the credit-default swaps they’ve sold.
Cancelling those bets (i.e., declaring them null, void, and legally unenforceable) would let swap sellers off the hook. It would in some sense leave the swap buyers high and dry in spite of the premiums they’ve payed. But, in fact, each period’s premium is for insurance for that period. The buyer has already gotten his/her coverage (fair value) for the period covered by that premium. That month’s premium is money that has been spent and for which value has already been received. So, I don’t feel that there is any (moral) obligation to the buyers to refund past premiums for credit-default swaps. Of course:
— Premiums for the current period should be refunded on a pro-rated basis from the cancellation date forward.
— Valid outstanding claims against CDS sellers filed prior to the cancellaton date should be enforced, and adjudicated in the courts if necessary.
IMHO, the cancellation of CDSs should be accompained by:
— the reinstatement of mark-to-market accounting (to reinstate trust among banks)
— government purchase of convertible, preferred, voting shares in criticial financial (to recapitalize them).