Thursday, March 5, 2009


According to a report in Bloomberg, there are increasing examples of traders almost pushing companies toward bankruptcy in order to benefit from credit default swap trades. The way it works if as follows. You buy a $1000 bond for $200 because the borrowing company is in such financial trouble. You then by insurance on the $1000 bond for $700, known as a credit default swap (CDS), which will pay you a $1000 if the company defaults on your loan.

The trader now would prefer bankruptcy over a restructuring because if there is a bankruptcy the trader gives the bond to the 'insurer' and receives $1000. So the trader gets $1000 and only spent $200 for the bond and $700 for the insurance. That's $100 profit. Multiply it be the number of bonds purchased and it is almost a no brainer for the trader. Unless of course the 'insurer' is a Lehman Brothers and fails to pay making the trader's CDS insurance an unsecured claim in the bankruptcy of the insurer.

As a side note, to make matters worse the 'insurers' also wrote CDS for traders who didn't own the underlying bond. Very similar to insuring a house for your benefit that you don't own. Think you would care if something happen to the house from a selfish financial standpoint?

Selling such insurance to traders that didn't own the underlying bond is how AIG was able to make large profits, pay large bonuses and then incur large losses and may continue to incur such losses. The press has been quiet about the looming CDS problem only because the other problems are too large and too immediate.

Cheers, Mike

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