Trying to make sense of arcane financial issues

Readers, I’d love your help on this one.

There was an article I read in Sunday’s New York Times that I found mildly terrifying. It focused on “credit default swaps“, a financial instrument invented about a decade ago to protect investors from losses when companies default on their bonds. This seems to me (as someone whose knowledge of financial markets is basically limited to handing money to mutual fund managers and reading the statements they send me) like a reasonable idea – some bonds are risky, and insurance might well be a reasonable hedge against that risk.

What’s scary is the size of the market, which according to Gretchen Morgenson in the Times, has grown from $900 billion to $45.5 trillion in the past eight years – the market now is twice the size of the US stock market. This isn’t just because people have wanted to insure their bond investments – credit default swaps have become a favorite way to bet against the health of a company. Instead holding a short position on bonds on GM, you can simply insure yourself against the collapse of bonds you don’t hold. The seller of the insurance – usually a bank or a hedge – is betting that the bonds will be honored, and will be paid insurance premiums in exchange for agreeing to compensate you for losses should the bond issuer default.

So far so good. But both sides of this contract are transferrable. That means that your insurer can sell your contract to another entity, who might be less able to honor the bargain. And you might find yourself trying to collect insurance from “Madame Merriweather’s Mudhut Phillipines” instead of from Citibank, as economics blogger Mike Shedlock suggests. Morgenson offers this analogy: “It would be as if homeowners, facing losses after a hurricane, could not identify the insurance companies to pay on their claims. Or, if they could, they discovered that their insurer had transferred the policy to another company that could not cover the claim.”

The fear, as I understand it, is that a major crisis of confidence in financial systems could occur if a big bond issuer – let’s say GM again – defaulted on its bonds. Those who hold CDSs on GM debt would try to collect from their insurers. If their insurers default, or if they can’t find their insurers, they’d find themselves taking significant, unanticipated losses. And other CDS holders, who bought the derivatives to hedge against bond risk, might realize that they had less protection than they thought and would have misvalued their holdings. ANZ Bank in New Zealand was forced to set aside $200 million because it holds a number of credit default swaps with ACA Capital, a New York bond insurer. ACA has had its credit downgraded from A to CCC due to losses in the subprime mortgage market. Because it is now below investment grade (way, way below), banks have to reassess the risk of their CDS hedges, as it’s possible ACA won’t be able to honor these contracts. So ANZ’s risk exposure is higher than they’d calculated, and they now need to set aside cash to cover those possible liabilities.

It’s not hard to find smart investors telling you that derivatives are a dangerous thing – Warren Buffet has said, “Derivatives are financial weapons of mass destruction.” But it seems too easy to just dismiss derivatives as making money from thin air, as some commenters have been quick to offer. It makes sense that investors would look for instruments to help them manage risk. It makes sense that one might want to purchase insurance on high-risk bond investments.

What I haven’t been able to understand is why this market is so freaking big. Shedlock observes that the market capitalization of GM is about $15 billion. There’s roughly a trillion dollars in credit default swaps linked to GM. This amount of money can’t just be a hedge against the possible failure of GM – investors could only lose $15 billion in bond holdings if GM collapsed. It’s not hard to imagine a huge fiscal catastrophe taking place if GM collapses and CDS holders discovering that they cannot collect on their insurance… or even find who’s holding those contracts.

So here’s what I’d love some help with – I’d very much like someone to explain to me why it makes sense for the derivative market in CDS to be so much larger than the market for the underlying securities. I’d also love someone to challenge Shedlock’s claims that it’s going to be extremely difficult to figure out who actually is responsible for these CDS’s and to collect against them in the case of corporate bankruptcy.

It strikes me that issues like this one represent a really serious challenge for reporters and bloggers. Clearly, the subprime mortgage crisis has had a huge impact on many people’s lives, both in America and around the world. Much of the media coverage of the situation focuses on concrete examples – here’s someone who lost a house in Detroit – rather than on large financial issues – was it really such a good idea to allow thousands of mortgages to be sold as a bundle as a single security? It strikes me that it’s very hard to concretize an issue like CDSs, and therefore, it’s pretty hard for an interested, but uninformed, reader to make much sense out of the issue. I find Shedlock much more readable than Morgenson, but I also get the sense that he’s got a serious axe to grind on the issue.

My friend Dan Caplinger, who is a regular contributor to the Motley Fool, has some very useful insights in the first comment below. Thanks for weighing in and making this a bit clearer, Dan.