Bear with me for a second here. This isn't an easy topic. That's because no one understands Credit-Default Swaps (CDSs), or other complex credit-derivatives, but it is important that we try to understand the implications of their exponential increase. Sure, some people claim to understand: hedge fund managers, investment bankers, etc. They understand the derivatives marketplace just like neuroscientists understand consciousness—they know the component parts, they can use them as tools barely under their control, but when it comes to understanding exactly how the greater dynamic emerges from the component parts they are in the dark.
No one really understands the credit-derivative market, but everyone is impacted by it. Credit-derivatives represent the creation of money out of thin air, like some act of financial wizardry. Take a Credit-Default Swap, for example. Here’s how it works: Corp. A needs to raise funds to expand operations, so they issue a $10 million bond. Pension Fund B buys that bond, but is concerned with the risk of Corp. A going bankrupt and defaulting on the bond. So Hedge Fund C offers what is, in effect an insurance policy—Pension Fund B pays Hedge Fund C $200,000, and in exchange if Corp. A defaults on the bond, Hedge Fund C covers the $10 million for Bank B. Here’s the magic: because this insurance policy creates the market for this otherwise too-risky bond from Corp. A in the first place, and because the par-value of the credit-default swap (the insurance policy) that the Hedge fund issues does nothing more than eat up the difference between the risk-premium on this bond, this $200,000 that the hedge fund makes is essentially fabricated out of thin air. Don’t forget to sprinkle in a liberal portion of fractional-reserve-banking fairy dust and viola: now you understand the credit-derivatives market as well as anyone else in the world.
Clear as mud? Try this on for size: there were $25 Trillion dollars in credit derivatives issued so far in 2006. That’s about half the size of the world economy. Oh, and it’s unreported, unregulated, and largely non-transparent. But wait, it gets better:
What is the effect of this absolutely massive trade in credit-derivatives? It has the effect of creating liquidity in the market for credit, but the larger effect is that it spreads risks very, very effectively. Because these credit-derivatives get pooled, sliced up, re-packaged, and re-sold, they have the effect of distributing the risk of default very, very broadly. Because virtually every hedge fund borrows from virtually every bank, which is connected to virtually every mutual fund, pension fund, and corporation, the risk of default is spread among virtually everyone. So this makes the world economy very, very resilient in the face of minor financial crises—say, the Asian Financial Crisis of the mid ‘90s, or the fall-out from September 11th. In fact, because of this massive trade in credit-derivatives, the world economy is actually far more secure in the face of your garden-variety financial crisis. This resiliency works as long as there’s enough slack, enough “spare capacity” in the world economy to absorb the distributed force of these defaults or crises. But at some tipping point—and because it’s not regulated and not transparent no one knows where this is—the stress cannot be absorbed. At this point, the crisis is no longer just a “recession” or a “depression”—it is a complete global collapse.
The market in credit-derivatives is a “financial weapon of mass destruction.” That’s not just my opinion, it’s a quote from the Oracle of Omaha himself, Mr. Warren Buffett (Berkshire Hathaway 2002 Quarterly Report, sorry, no link). Complex societies such as ours collapse because diminishing marginal returns eventually weaken a society until it cannot overcome periodic stressor events. The continually advancing sophistication of the derivatives markets represent the desperate efforts of the global economic system to climb high enough to reach even the hardest to reach fruit from the marginal-return orchard. The irony of a derivative collapse is that it will afford us the illusion that not only is everything OK, but that it is actually continually improving and expanding right up until the point where the whole house of cards implodes.