Credit Default Swaps Were The Worst Form of Gambling From Wall Street

In an interesting piece appearing in Market Oracle, that site pretty much makes it clear that Wall Street was gambling when it came to those so-called Credit Default Swaps:

Martin Hutchinson writes: When it comes to naming a winner in the competition for "the worst product ever invented by Wall Street," there is quite a list of worthy candidates. With just the current financial crisis alone there are such "inventions" as subprime mortgages, auction rate preferred stock    Then there's also the credit default swaps.

That website appropriately referred to these Credit Default Swaps as "Misguided Missiles". 

On Monday, the government announced that the already-hard-pressed U.S. taxpayer is being forced to put another $30 billion into AIG , bringing the total rescue package, thus far, to $180 billion.

For those with short memories, by far the largest portion of AIG's losses has come in the $50 trillion credit default swap market, which was instituted only in 1995. Other Wall Street products have caused huge losses, but have spent decades growing before they did so, producing sober profits for many years before blowing up.

[Just yesterday (Tuesday), in fact, U.S. Federal Reserve Chairman Ben S. Bernanke verbally ripped AIG - saying the insurer operated like a hedge fund, while stating that having to rescue the insurer made him "more angry" than any other episode during the financial crisis - because of how its mishandling of credit default swaps led to the company's implosion.]

It is increasingly clear that CDS's have produced profits only for the dealing community, and only for a few years. Even by Wall Street's abominable standards, they thus have a rightful claim to be considered the worst financial "product" ever invented.

Under a credit default swap, if Institutional Investor "A" has a $10 million loan to Megacorp, Institutional Investor "B" can agree to cover the credit in that loan. In other words, if Megacorp defaults, "B" has to cover the debt. But "B" collects a small insurance premium for agreeing to cover the loan - a premium it gets to pocket as income.

Typically, payments under a Megacorp CDS are triggered either by a bankruptcy or by Megacorp failing to pay interest or principal on its debts. Because hedge funds and others gamble with these financial instruments, the problem arises in that the volume of credit default swaps currently outstanding is far greater than the volume of the loans themselves.

Gambling911.com has found the best comparison between Credit Default Swaps and gambling here - at The Science Blogs:  Good Math, Bad Math:

In gambling terms, you can look at the CDS as a bet that the a loan is going to default. You want to be covered in case the loan defaults; so to protect yourself, you make a high-odds bet against your investment. Then if the investment goes bad, the bet pays off.

A bookie wants to make money no matter what happens. If he's taking bets on a boxing match, then he'll offer odds to different betters in a way that producing a balance. Suppose you're looking at a fight between Freddie the Fighter and Charlie the Challenger. How does a bookie set the odds of the fight of Charlie verses Freddie? He looks at who's betting which way, and sets up the odds so that no matter who wins, he'll have enough money to pay the people who bet on the winner, with some left over for himself. If the fighters are very evenly matched, and the bets are running even, then he'll give equal odds: bet 1 dollar for charlie, and if you win, you'll get back an extra dollar. If Charlie is really a hobo who Freddie's promoter hired to take a fall to extend Freddie's undefeated record, then the odds are going to run very heavily against Charlie: betting for Freddie to beat Charlie could only pay off $0.001 for each dollar bet, whereas betting $1 for Charlie would win $1000 if he won. The bookie is going to manage the odds that he's giving betters to mantain the balance.

Credit default swaps are a form of bet, and they're working inside of a market, which acts as a sort of headless bookie. The market effectively sets the odds in a way that strikes a balance. A credit default swap is, basically, a bet that a particular loan will default. So if I'm bank A, and I'm loaning a billion dollars to bank B, I want to be sure that I'll get my money back. One way of doing that is, basically, to place a bet. I bet that bank B is going to default on the loan. Since B is very unlikely to default, the odds on that bet are huge - I can bet one million dollars that they'll default, and if they do, the bet will pay off all $1 billion.

The problem with this is that no one is going to take the other down side of the bet. On one side, you've got someone who wants insurance against an exceeding unlikely event - so they're willing to put up some money, effectively betting on a very unlikely outcome, but with huge payoff odds - things like better $1 million that a bank will default, expecting to lose the million, but with the proviso that if the bank defaults, they'll get a $1000 to 1 payoff. But on the other side, you're talking about putting $1 billion to win a paltry $1 million. That makes no sense at all - no one's going to put up a billion dollars for a return of one tenth of one percent! To try to get around this, the people who set up the market sweeten the deal in two ways.

First, if you take the bet against the bank, the money that gets bet is yours. So if the other guy bets $1 million that the bank will default, you get a million dollars up front.

Second, if you take the bet against the bank, you don't have to put up the money up front. By taking the money bet by the other guy, you're making a commitment to pay up if the unlikely event occurs, but you don't need to pay up front. So, you get to take the money bet by the other guy, and you don't need to tie up your own money. Odds are, that's a damned good deal. You're getting money for doing nothing.

Looked at in gambling terms, the CDS looks pretty much like a scenario where you go to the bookie, and say "I want to bet on the champ defeating the hobo"; and the bookie just gives you the money bet on the hobo winning, and takes himself out of the picture. If the hobo does win, you're holding the bag to to pay off everyone who bet on the hobo at huge odds. The bookie didn't make sure that you had enough money to pay off the bets if the hobo won. The bookie doesn't really care; he's not losing anything. If the bettor can't come up with the money, it's the other bettors who won't get paid. The bookie is just an agent for connecting up the betters on the two sides; the question of who's going to be stuck paying the betters isn't his problem.

Jagajeet Chiba, Gambling91.com