Talkin’ About Credit-Default Swaps

Why being bearish on them means you're likely bullish in general

Now of course, we know all about credit-default swaps. And we know that you know all about credit-default swaps. I mean, who doesn’t, after all the talk of them in recent months? Duh. And you’d have to be a moron not to know their relationship to collateralized debt obligations. Hello? But Dean Starkman, who knows everything, thought it might be useful to lay out—for other people—a primer on what they’re about.

So Dean called a Friend of The Audit and pretended he didn’t know much about this debt insurance, which investors use to hedge their risk or to bet against companies. Madcap hilarity ensued:

The Audit: CDSs are a bet against collateralized debt obligations and other mortgage-supported debt, right?
Friend of The Audit: Or against anything other kind of debt obligation, like a company’s bonds.

TA: So if you issued CDSs, like MBIA, you are in bad shape because CDOs are bad and going to get worse.

FOTA: Yep.

TA: If you bought CDS contracts from MBIA, you are happy.

FOTA: Well, at least you thought you were happy. You might not be happy anymore, because you might be afraid that MBIA will default, in which case you probably won’t get paid.

TA: To believe there is a “bubble” in CDSs means that you believe that CDOs are not as bad as widely believed, that our economic troubles may not be as bad and that the financial system may recover quicker than others believe. A bear on CDSs is a bull generally.

FOTA: Basically, yes. A bear on CDSs might not be an outright bull. Might be more like a slowly grazing cow, mooing, “Hey, c’mon, things aren’t as bad what the mark-to-market losses would have you believe.”

TA: If MBIA defaults, that means the credit market is in worse shape than we think.

FOTA: If by “we” you mean conventional wisdom, yes.

TA: How am I doing so far?

FOTA: Splendid.

TA: Question: Are AIG’s problems that it issued CDSs or owns CDOs or what?

FOTA: Its main problem is that it issued CDSs. In effect, it’s insuring against default on a lot of CDOs.

Ryan Chittum is a former Wall Street Journal reporter, and deputy editor of The Audit, CJR's business section. If you see notable business journalism, give him a heads-up at Follow him on Twitter at @ryanchittum.