April 30, 2009 • 21 mins
In theory, credit default swaps are simply insurance against failed investments. In reality, these swaps can quickly get complicated. Tune in to this podcast from HowStuffWorks.com to hear Josh and Chuck demystify credit default swaps.
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Episode Transcript
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Speaker 1 (00:00):
Brought to you by the reinvented two thousand twelve Camray.
It's ready. Are you welcome to Stuff you should know
from house Stuff Works dot com? Hey, and welcome to
the podcast. I'm Josh Clark and guess who's with me?
M Ronald McDonald? Yes, I met Ronald McDonald. That my
cousin's ride tame birthday already? Really? Yeah, it's pretty cool. No, weird,
(00:23):
that's the first thing that came into my head. I
guess it means I'm hungry. I guess, so are you hungry?
Did you eat today? This is gonna be a fun one.
Shock you're talking about credit to fault swaps. I know
we're gonna try to make it sexy. Yes? Should I
go ahead and get the caveat here? If you want?
Go ahead? I just want folks to know we usually
Josh and I do a lot of prep work and
(00:43):
both have a pretty good understanding. But I'm not ashamed
to admit that I didn't quite understand this one, and
so it's pretty thick. Yeah, it might be a little
different today Josh is going to be teaching me along
with you. So, okay, are you prepared as prepared as I?
Can I appreciate you dressing like a little school girl
today to really kind of complete everything round it out? Um? Okay,
(01:05):
so well, let me give you an analogy, all right, Okay, So, Chuck,
Imagine if I went to your health insurance provider, right
and said, hey, I want to buy Chuck policy okay,
and they said okay, and they sold it to me,
and you would be in charge of that policy. I
would own the policy, so I'd be I'd be accepting
monthly payments from you. Everything would be fine. I'd be
(01:27):
probably running around trying to keep you out of accidents
that kind of thing. But if you did get into
an accident, I would be on the hook to pay
your medical expenses, right, you bet you would be. You
and I are both fully aware that I don't have
the money to pay your medical expenses. So basically what
would happen is I'd pay as much as I could
until I bankrupted myself, and then you'd be on the
(01:49):
hook to pay your medical expenses. Right, I get that.
So you'd be in trouble, it bankrupt you and we'd
both be up the creek, I understand. So are you
with me? So? Are that makes sense now? Imagine if
you owned two other people's life or health insurance policies
(02:09):
just like I owned yours. Okay, sure, Now let's say
you that accident you got into was a three car
pile up, just in a mind boggling coincidence with the
other two people whose health insurance policies you owned with you.
So now all of a sudden, you guys are all
in an accident, all need healthcare, and nobody has the
money to pay out. I can't pay yours, and you
(02:31):
have your own problems, so you can't pay the other
two peoples. So imagine if this just keeps going on
and on and on and on in this infinite car
pile up, and everybody owns everybody else's insurance policy but
nobody can pay. Okay, seems it does. It is awful.
It's kind of nightmares. Right. So the good thing is
that this can't happen because health insurance is a heavily
(02:54):
regulated industry. So you've got um you have federal inspectors
who can go to a health inst and say, let
me see your books. I want to make sure you
can cover every policy that you have. Right, did they
do that? Yeah? And what's more, they can't sell your
insurance policy to anybody, right, okay. Right, with credit default swaps,
(03:14):
all the all the good things that keep health insurance
from going pear shapes are not present, although they are
pretty much insurance policies on debt. Okay, okay, this is
where I start to get a little fuzzy. I understand
it does get a little fuzzy at this point. It's
a bit of an abstract. Um, it's a bit abstract
for me. It is, it's insane. You have to be
(03:35):
a a genuinely savvy person and possibly a bit evil
to be able to really accurately trade or make money
in credit default swaps. But you don't have to be
evil to describe them to people in podcast land. No, No,
you just have to read them, read the article several times,
and write it too. It doesn't hurt to write it
(03:57):
several times, and it was still a little bit maybe
you have to write it writing it out. Um, okay,
So let me give you a little bit background credit
default swaps for these financial instruments that came out of
the late nineties. Right, it's a derivative. It is a derivative,
and a derivative is a derivative. I do know this.
It's a financial instrument, UH that has a value based
on the value of another financial instrument. Right. So let's
(04:19):
say you're trading in oil futures, right, UM that actually
the value of that future is based on the value
of oil. It has an actual value, right. UM. With this,
this would be based on UH future and oil future. Right.
So it doesn't have its own value. Its values based
on the value of something else. So let's say you
(04:40):
bought a bunch of oil futures and you were worried
that the price of oil was going to go down, right,
and so you'd be getting the oil cheaper oil for
than what you paid for it. You would you would
lose money. You could I'm not sure if you could
or not, But let's say theoretically you could buy a
credit default swap to cover that eventuality. So it's like insurance.
(05:05):
That's exactly what it is. So in the nineties, UM,
they started issuing these things on municipal bonds, which are
or about as safe as it gets. UM. Almost every
city except for probably Detroit, has a triple a UM
credit rating. Right. So a municipal bond is a loan
made to a city to finance a project. That's why
(05:26):
it's a little more stable than your average situation. Right,
And the city can tax its citizens to pay off
its debts, which is one of the reasons why they're
so stable and reliable and credit worthy. Right, gotcha. So
the thing is, like all these banks that are issuing
these policies are saying, you know what, we're making just
tons of extra income because they're they're um selling these
(05:48):
credit default swaps to people who are loaning money to cities.
The cities are definitely paying it back, so there's no
there's no um default on the loan, and so the
banks are just can inect your money. So these things
started to take off like a rocket. Who's the day,
That's what I'm confused about. That's the bank they actually
issue these. Okay, so let's say let's say that, um,
(06:09):
I have a bunch of money and Atlanta needs to
repay four hundred so I buy a bunch of city bonds,
a bunch of municipal bonds, which are basically it's a
city issuing debt. I give them a bunch of money
and then give me a bond and return to hang
on too, and I'll earn like slow, steady, small interest. Right,
(06:31):
I would buy a credit default swap from a bank,
right to say, if this city doesn't pay me back,
then I can cash in this credit default swap, this
insurance policy against the against the the the loan I
gave the city, Okay, and then I'll actually make more
(06:51):
money because like a life insurance policy, it has it's
worth more than say the actual loan. Okay, se coming
into focus, Okay, is it? Is it? Okay, we should
we should talk together before we do these ruin everything. Yeah,
I guess you're right. Yeah, so um okay, so the
so the It made a huge source of extra income
(07:12):
for the banks that were issuing these these insurance policies
because no municipality was defaulting on their loans, right, Um,
So they started to look for other places where they
could sell these things or people they could sell them to,
of course, and essentially you can cover any debt whatsoever,
um with a credit default swap. Well, that's amazing to me.
(07:34):
And I think one of the reasons why it was
able to take to take off like this is because
they're unregulated. It seems like, you know, greed as always
kind of takes hold they're like, hey, if we do
it for this, we can do it for this is
how it worked. They're wholly and completely to this day unregulated.
It's amazing. So, which is why that that scenario that
I gave you at the beginning about your health insurance policy,
(07:56):
that's dead on with credit default swaps. So think about this.
Say a bank issues, um, a credit default obligation to
somebody who has um created debt. Right Um. That that
guy who loaned money to the city for that road project. Okay,
so he buys a credit default sat. Now there's two
players in this one. Really, as far as the insurance
(08:19):
policy goes. You've got the bank who has the issuers
side of it, and then you've got me, uh, the
guy who made the loan to the city, who has
the buyer's side of it. And you pay a premium
like right um, And then both of the sides of
this policy can be sold to anybody at any time
who wants to buy them, and neither side needs to
(08:41):
notify the other person. Really, what's more, because it's unregulated, Um,
if the bank sells it to you, right, so, now
you own the issuer portion of my credit default swap.
So I'm now making payments to you. You don't have
to prove to them at all whether you have the
money to cover it. If that, if the city defaults
(09:04):
on the loan. This sounds two things. This strikes me.
It sounds like la la land, and it sounds like
a really bad idea. It is because, Chuck, here's the problem,
right if you if we haven't come up with enough
problems yet. Um, since it's also since it's unregulated, the
way that a credit default swap can be called in
(09:26):
if I'm the buyer is through a credit event, and
there's certain credit events, one of the big ones bankruptcy.
One of them is if the city just says we're
not repaying your loan, that would be a credit event,
right right, and then that triggers payment problem is since
they're unregulated, anybody can dispute whether or not a credit
event actually took place, whether the event that the buyer
(09:50):
is saying, give me my money over actually was a
credit event. So there's mediation, there's lawsuits. Well who did
they dispute it to? Though, since there's nobody they take
the other person to course, they just start seeing each other. Yes,
more litigation, that's exactly what we need. Right. Um. The
thing is, it's it's still, like I said, to this day, unregulated.
There's actually an independent body of banks and investment houses
(10:14):
and other other investors uh and securities analysts I believe,
who have come together to form an arbitrating panel for
credit default swaps. That's a good thing, right, it is
a good thing. But again, it exists outside of the government.
So everybody who's involved in the credit default market had
to agree, Yes, we'll listen to these people. Their decision
(10:36):
is binding. But is that I mean, existing outside the government,
and it isn't necessarily a bad thing. No, it isn't.
But I think to me, it's just kind of one
more point, like where's the SEC. And I actually read
that the SEC and the Treasury Department we're encouraging this
panel to form, like please go handle this for us
because we don't have any teeth whatsoever. Um. So yeah,
(10:58):
so that's the problem with being unregulated, right, Well, it
sounds like it's right for a nightmare scenario to like,
first we're talking about let me let me set the
stage for you, okay, okay. In July two thousand seven,
you remember the good, heady days of the bubble before
at first, okay, the um the subprime mortgage market was
(11:19):
valued at. Uh, let's see, I think seven trillion dollars
in the US and them in the US. But the
US is I think the biggest player in the subprime
mortgage market, right, And this is when the subprime mortgage
market was still valuable. So seven trillion. Do you know
in July two thousand seven, what the credit default swaps
(11:40):
market was valued at? I do, but I'm gonna let
you say it. Are you ready? Sixty two trillion dollars?
That's unbelievable. Do you know what the global g d
P was for two thousand and eight? I do, but
I'm gonna let you say it. You're ready? Sixty nine
trillion dollars? Wow, So it's short of the globe of
(12:01):
the global GDP. So basically, if every country in the
entire world could suddenly sell off everything, every good in
service that produced any year to say some aliens, right,
we'd still just we'd have like five trillion dollars left
over for the year. It sounds like this is the
biggest market of anything in the world. Almost, Yes, yeah,
it's I think, So I can't I can't think of
(12:22):
anything that that's valued up more than that and it
just think about it. This is the the late nineties,
So in a decade, this unregulated market went from zero
to sixty two trillion. Well, what's amazing is like your
references the mortgage crisis, and that's a scenario you can
you can track it down to a house eventually, like
(12:42):
a physical property. But this is sort of like exist
in the ether, So where there's no end of the line,
it seems like no, there isn't um, which is why
you can say no credit credit event didn't occure, or no,
I'm not gonna pay up, or I don't have the
money to pay up. I'm sorry. I was enjoying the
monthly payments you're paying me and I really thought you
were gonna be okay. But now that you've gone under,
(13:05):
I can't. I can't pay you. You know, I can't
pay you um the money that I owe you, Right,
so what does this us? Well, hold on, let me
say one more thing. The whole reason this this market
blew up was because it's actually a way to bet
on the health of a company. Right, So if you
have a bunch of investors who have buyers shares of
(13:26):
credit default swaps. Then they're saying, uh, they think that
that company is gonna go under because they're paying monthly premiums.
But it's on the premise that you um that that
company is gonna go under, and there will be a
much bigger payout, yes, even more. Um, you can actually
short sell a company, driving its value down if you
(13:47):
if you own enough shares, or you can borrow enough
shares and sell them on a margin. Um. If you
have credit default swaps, it'll actually be a bigger payout
if you can drive that company into bankruptcy because you've
just created a credit event that seeing is unbelievable. Okay,
So this is where the world was teetering right now.
And in two thousand seven eight um Lehman Brothers actually
(14:07):
went down not because of subprime mortgage securities, but because
of all the credit default swaps. This huge domino effect
was triggered. A bunch of people had credit default swaps
on the subprime mortgage securities that they owned, right oops. Indeed,
so when the subprime mortgage securities went south, everybody turned
to their credit default swaps. I'm like, well, I'm I'm
(14:28):
glad I have these. Now, wait a minute, who owns
my policy? Because there's no paper trail whatsoever you have,
you track down who owns it and then hope that
they have the money to pay you. All these banks
were finding out the people that own their their um
their insurers policy, uh, didn't have the money to pay them.
The problem is is when you're writing your balance sheet.
If you have a major loss, but you have a
(14:49):
credit default swap that covers it and it pays out,
you're fine and you're staying in the red and you
probably actually made a little bit of money. If you
have a major loss and there's no credit default swap
to cover it can't be covered, then that's when your
balance she goes into I'm sorry, into the red, right,
which is the bad one? Right right? Yeah, I get that. Okay,
(15:09):
so um, that's what happened with Lehman Brothers. That's why
A I G got all of that bail out money
because they had a bunch of credit to fault swaps.
And now there's this panel that I talked about, the
independent panel that's actually gotten the value of the market
down to about twenty trillion. I wonder, however, dependent Well, yeah,
I think it's probably all revolving door and stuff like
(15:32):
they if they haven't held public office in the last
couple of years, they will work for Goldman Sax. I
think Goldmen Sex is a major player in that panel. Yeah,
well this sounds like I get it now, do you really? Yeah? Yeah? Yeah, alright,
so thanks for that, but thank you. Where does this lead?
I mean, is this uh, something's got to happen at
some point. It seems like or else it's setting us
up for even more failure economically, right, No, no, no, no,
(15:56):
most definitely. I think it's just um, it seems like
the credit of fault swaps market is being tamed. Like
I said, we've gone from sixty two trillion to twenty
trillion in just like two years. But I think it's
symptomatic of the lack of regulation and oversight that that
we've had. We have the SEC, but they don't have
any teeth in the teeth that they do have or
(16:17):
dole and and can basically just gum butter, you know. Um.
And then the fact that there's a whole over the
counter markets that are allowed to get this big without
any regulation whatsoever. I think it seems there seems to
be a pattern, Chuck, like the Great Depression was the
result of complete and total lack of oversight and regulation
(16:39):
mixed with unbridled Greek. Right, So then we come up
with things like the SEC, the FDA, all these things
that all these regulatory bodies that came out of the
Great Depression in the in the crash to prevent it
from happening again. Then we got lazy, so then this
happened again. There's going to be more regulation. The problem
is people always say, you know, pro business people always
(17:00):
a you know, regulation strangles business. I disagree. I think
the whole point to um capitalism is to make as
much money as you can as fast as you can write,
which means that no matter how many roadblocks the government
throws up, all it's doing is presenting challenges for very clever,
greedy people, and they'll always find a loophole always. Yeah.
(17:22):
So I think that's where it's leading us to more regulation.
But I don't think there's ever going to be a
saving grace where nothing like this ever happens again. Well,
when you're talking now trillion dollars, that's still such a
massive amount that it's it's kind of frightening to think
about it is, but it's doable. I think if the US, Japan,
and the UK got together and sold everything off in
(17:44):
a fire cell, we could cover it. Yeah all right,
well I get it. Thanks good, I'm feeling pretty good
about myself. Were default swaps? Ahoy? Yeah, this this was
sort of like some math kind of just goes so
far above my head. I can read it and read
it and read it and it still just doesn't sink in.
I'm like that with the algebra. I get geometry, but
(18:05):
not algebra. We should do a podcast on it and
fumble our way through that so we could. Yeah, yeah,
so there you have. It's awesome. All right, Are we
still plugging things anymore? Sure? Josh. We'll just give a
quickie plug to the blog. Alright, blog and stuff you
should know blog that we write um once a day
each and it's on the right side of the homepage.
Very nice and it's been enjoyable and that's all we
(18:27):
need to say. Yes, that is it? So then what
does that mean? Chuck's listener mail time? It is indeed,
And Josh, this one I'm really looking forward to reading.
Which one is it? This is the I ME incident?
We get a lot of these uh for those of you.
Obviously you don't know because you don't get a listener mail.
(18:47):
We have a lot of people that take us to
task on the use of I and me, Josh and I,
Josh and me and me and josh I and Josh
I seem to get it a lot more than you,
though we both do. We Yeah, So if people take
us to task and tell us that we're not being
a responsible uh with our grammar. And I got this
email from Keith and Alton, Illinois, and Keith says, I
(19:11):
just want to let you know that as a student
of linguistics, I'd like to tell you that in a
compound object e g. Send listener mail to Chuck and
I slash me, it is totally fine to use whichever
pronoun you think sounds better. I've read a link the
explanation that justifies the use of eye in a compound object,
but I won't bore you with it. My main point
is this talk in whatever way it sounds right to you,
(19:33):
while keeping in mind that certain non standard usage of
words might put off some snooty pedants. Awesome, Keith, and
he did actually send a link. I'm not gonna bore
you either. But there was a book by Steven Pinker
called The Language Instinct, and uh, I mean he sent
me a whole page where the guy basically breaks it
(19:53):
down and in the end, I'll just read the one
sentence Stephen Pinker. Really yeah, Ok, do you know him?
I just heard of him last night for the first time.
Really yeah, it's odd. How about that? So? Uh, The
last sentence of his thing says, by the logic of grammar,
the pronoun is free to have any case it wants.
I agree. I think the point of communication is to
(20:16):
get your get your idea across to somebody exactly. And
I think interchanging iron me so gets the point across. Yeah.
I think if you can get your point across with
grunts and hand gestures or if that's proper communication. Right.
And when it comes down to it, the name of
this show is not grammar. You should know, right. And
we are always the first ones to say we're not
you know, we're not perfect, so uh layoff. Yeah a
(20:39):
matter of fact, Keith, go ahead and send us your
your address because we're gonna send you a T shirt.
My man, that was cool, Thanks for coming to the rescue. Yeah, Keith,
shirt size and address, and well, thank you for having
our backs on this. So if you want to have
our backs, if you want to take us the task,
if you're a grammar Nazi or a well whatever, how
(21:00):
about we re record that part ready. So if you
want to have our backs or you want to take
us to task like the grammar Nazis that rode in Um,
just go ahead and send us an email to stuff
podcast at how stuff works dot com for more on
(21:21):
this and thousands of other topics. Does it how stuff
works dot com m brought to you by the reinvented
two thousand twelve camera. It's ready, are you
Brought to you by the reinvented two thousand twelve Camray.
It's ready. Are you welcome to Stuff you should know
from house Stuff Works dot com? Hey, and welcome to
the podcast. I'm Josh Clark and guess who's with me?
M Ronald McDonald? Yes, I met Ronald McDonald. That my
cousin's ride tame birthday already? Really? Yeah, it's pretty cool. No, weird,
(00:23):
that's the first thing that came into my head. I
guess it means I'm hungry. I guess, so are you hungry?
Did you eat today? This is gonna be a fun one.
Shock you're talking about credit to fault swaps. I know
we're gonna try to make it sexy. Yes? Should I
go ahead and get the caveat here? If you want?
Go ahead? I just want folks to know we usually
Josh and I do a lot of prep work and
(00:43):
both have a pretty good understanding. But I'm not ashamed
to admit that I didn't quite understand this one, and
so it's pretty thick. Yeah, it might be a little
different today Josh is going to be teaching me along
with you. So, okay, are you prepared as prepared as I?
Can I appreciate you dressing like a little school girl
today to really kind of complete everything round it out? Um? Okay,
(01:05):
so well, let me give you an analogy, all right, Okay, So, Chuck,
Imagine if I went to your health insurance provider, right
and said, hey, I want to buy Chuck policy okay,
and they said okay, and they sold it to me,
and you would be in charge of that policy. I
would own the policy, so I'd be I'd be accepting
monthly payments from you. Everything would be fine. I'd be
(01:27):
probably running around trying to keep you out of accidents
that kind of thing. But if you did get into
an accident, I would be on the hook to pay
your medical expenses, right, you bet you would be. You
and I are both fully aware that I don't have
the money to pay your medical expenses. So basically what
would happen is I'd pay as much as I could
until I bankrupted myself, and then you'd be on the
(01:49):
hook to pay your medical expenses. Right, I get that.
So you'd be in trouble, it bankrupt you and we'd
both be up the creek, I understand. So are you
with me? So? Are that makes sense now? Imagine if
you owned two other people's life or health insurance policies
(02:09):
just like I owned yours. Okay, sure, Now let's say
you that accident you got into was a three car
pile up, just in a mind boggling coincidence with the
other two people whose health insurance policies you owned with you.
So now all of a sudden, you guys are all
in an accident, all need healthcare, and nobody has the
money to pay out. I can't pay yours, and you
(02:31):
have your own problems, so you can't pay the other
two peoples. So imagine if this just keeps going on
and on and on and on in this infinite car
pile up, and everybody owns everybody else's insurance policy but
nobody can pay. Okay, seems it does. It is awful.
It's kind of nightmares. Right. So the good thing is
that this can't happen because health insurance is a heavily
(02:54):
regulated industry. So you've got um you have federal inspectors
who can go to a health inst and say, let
me see your books. I want to make sure you
can cover every policy that you have. Right, did they
do that? Yeah? And what's more, they can't sell your
insurance policy to anybody, right, okay. Right, with credit default swaps,
(03:14):
all the all the good things that keep health insurance
from going pear shapes are not present, although they are
pretty much insurance policies on debt. Okay, okay, this is
where I start to get a little fuzzy. I understand
it does get a little fuzzy at this point. It's
a bit of an abstract. Um, it's a bit abstract
for me. It is, it's insane. You have to be
(03:35):
a a genuinely savvy person and possibly a bit evil
to be able to really accurately trade or make money
in credit default swaps. But you don't have to be
evil to describe them to people in podcast land. No, No,
you just have to read them, read the article several times,
and write it too. It doesn't hurt to write it
(03:57):
several times, and it was still a little bit maybe
you have to write it writing it out. Um, okay,
So let me give you a little bit background credit
default swaps for these financial instruments that came out of
the late nineties. Right, it's a derivative. It is a derivative,
and a derivative is a derivative. I do know this.
It's a financial instrument, UH that has a value based
on the value of another financial instrument. Right. So let's
(04:19):
say you're trading in oil futures, right, UM that actually
the value of that future is based on the value
of oil. It has an actual value, right. UM. With this,
this would be based on UH future and oil future. Right.
So it doesn't have its own value. Its values based
on the value of something else. So let's say you
(04:40):
bought a bunch of oil futures and you were worried
that the price of oil was going to go down, right,
and so you'd be getting the oil cheaper oil for
than what you paid for it. You would you would
lose money. You could I'm not sure if you could
or not, But let's say theoretically you could buy a
credit default swap to cover that eventuality. So it's like insurance.
(05:05):
That's exactly what it is. So in the nineties, UM,
they started issuing these things on municipal bonds, which are
or about as safe as it gets. UM. Almost every
city except for probably Detroit, has a triple a UM
credit rating. Right. So a municipal bond is a loan
made to a city to finance a project. That's why
(05:26):
it's a little more stable than your average situation. Right,
And the city can tax its citizens to pay off
its debts, which is one of the reasons why they're
so stable and reliable and credit worthy. Right, gotcha. So
the thing is, like all these banks that are issuing
these policies are saying, you know what, we're making just
tons of extra income because they're they're um selling these
(05:48):
credit default swaps to people who are loaning money to cities.
The cities are definitely paying it back, so there's no
there's no um default on the loan, and so the
banks are just can inect your money. So these things
started to take off like a rocket. Who's the day,
That's what I'm confused about. That's the bank they actually
issue these. Okay, so let's say let's say that, um,
(06:09):
I have a bunch of money and Atlanta needs to
repay four hundred so I buy a bunch of city bonds,
a bunch of municipal bonds, which are basically it's a
city issuing debt. I give them a bunch of money
and then give me a bond and return to hang
on too, and I'll earn like slow, steady, small interest. Right,
(06:31):
I would buy a credit default swap from a bank,
right to say, if this city doesn't pay me back,
then I can cash in this credit default swap, this
insurance policy against the against the the the loan I
gave the city, Okay, and then I'll actually make more
(06:51):
money because like a life insurance policy, it has it's
worth more than say the actual loan. Okay, se coming
into focus, Okay, is it? Is it? Okay, we should
we should talk together before we do these ruin everything. Yeah,
I guess you're right. Yeah, so um okay, so the
so the It made a huge source of extra income
(07:12):
for the banks that were issuing these these insurance policies
because no municipality was defaulting on their loans, right, Um,
So they started to look for other places where they
could sell these things or people they could sell them to,
of course, and essentially you can cover any debt whatsoever,
um with a credit default swap. Well, that's amazing to me.
(07:34):
And I think one of the reasons why it was
able to take to take off like this is because
they're unregulated. It seems like, you know, greed as always
kind of takes hold they're like, hey, if we do
it for this, we can do it for this is
how it worked. They're wholly and completely to this day unregulated.
It's amazing. So, which is why that that scenario that
I gave you at the beginning about your health insurance policy,
(07:56):
that's dead on with credit default swaps. So think about this.
Say a bank issues, um, a credit default obligation to
somebody who has um created debt. Right Um. That that
guy who loaned money to the city for that road project. Okay,
so he buys a credit default sat. Now there's two
players in this one. Really, as far as the insurance
(08:19):
policy goes. You've got the bank who has the issuers
side of it, and then you've got me, uh, the
guy who made the loan to the city, who has
the buyer's side of it. And you pay a premium
like right um, And then both of the sides of
this policy can be sold to anybody at any time
who wants to buy them, and neither side needs to
(08:41):
notify the other person. Really, what's more, because it's unregulated, Um,
if the bank sells it to you, right, so, now
you own the issuer portion of my credit default swap.
So I'm now making payments to you. You don't have
to prove to them at all whether you have the
money to cover it. If that, if the city defaults
(09:04):
on the loan. This sounds two things. This strikes me.
It sounds like la la land, and it sounds like
a really bad idea. It is because, Chuck, here's the problem,
right if you if we haven't come up with enough
problems yet. Um, since it's also since it's unregulated, the
way that a credit default swap can be called in
(09:26):
if I'm the buyer is through a credit event, and
there's certain credit events, one of the big ones bankruptcy.
One of them is if the city just says we're
not repaying your loan, that would be a credit event,
right right, and then that triggers payment problem is since
they're unregulated, anybody can dispute whether or not a credit
event actually took place, whether the event that the buyer
(09:50):
is saying, give me my money over actually was a
credit event. So there's mediation, there's lawsuits. Well who did
they dispute it to? Though, since there's nobody they take
the other person to course, they just start seeing each other. Yes,
more litigation, that's exactly what we need. Right. Um. The
thing is, it's it's still, like I said, to this day, unregulated.
There's actually an independent body of banks and investment houses
(10:14):
and other other investors uh and securities analysts I believe,
who have come together to form an arbitrating panel for
credit default swaps. That's a good thing, right, it is
a good thing. But again, it exists outside of the government.
So everybody who's involved in the credit default market had
to agree, Yes, we'll listen to these people. Their decision
(10:36):
is binding. But is that I mean, existing outside the government,
and it isn't necessarily a bad thing. No, it isn't.
But I think to me, it's just kind of one
more point, like where's the SEC. And I actually read
that the SEC and the Treasury Department we're encouraging this
panel to form, like please go handle this for us
because we don't have any teeth whatsoever. Um. So yeah,
(10:58):
so that's the problem with being unregulated, right, Well, it
sounds like it's right for a nightmare scenario to like,
first we're talking about let me let me set the
stage for you, okay, okay. In July two thousand seven,
you remember the good, heady days of the bubble before
at first, okay, the um the subprime mortgage market was
(11:19):
valued at. Uh, let's see, I think seven trillion dollars
in the US and them in the US. But the
US is I think the biggest player in the subprime
mortgage market, right, And this is when the subprime mortgage
market was still valuable. So seven trillion. Do you know
in July two thousand seven, what the credit default swaps
(11:40):
market was valued at? I do, but I'm gonna let
you say it. Are you ready? Sixty two trillion dollars?
That's unbelievable. Do you know what the global g d
P was for two thousand and eight? I do, but
I'm gonna let you say it. You're ready? Sixty nine
trillion dollars? Wow, So it's short of the globe of
(12:01):
the global GDP. So basically, if every country in the
entire world could suddenly sell off everything, every good in
service that produced any year to say some aliens, right,
we'd still just we'd have like five trillion dollars left
over for the year. It sounds like this is the
biggest market of anything in the world. Almost, Yes, yeah,
it's I think, So I can't I can't think of
(12:22):
anything that that's valued up more than that and it
just think about it. This is the the late nineties,
So in a decade, this unregulated market went from zero
to sixty two trillion. Well, what's amazing is like your
references the mortgage crisis, and that's a scenario you can
you can track it down to a house eventually, like
(12:42):
a physical property. But this is sort of like exist
in the ether, So where there's no end of the line,
it seems like no, there isn't um, which is why
you can say no credit credit event didn't occure, or no,
I'm not gonna pay up, or I don't have the
money to pay up. I'm sorry. I was enjoying the
monthly payments you're paying me and I really thought you
were gonna be okay. But now that you've gone under,
(13:05):
I can't. I can't pay you. You know, I can't
pay you um the money that I owe you, Right,
so what does this us? Well, hold on, let me
say one more thing. The whole reason this this market
blew up was because it's actually a way to bet
on the health of a company. Right, So if you
have a bunch of investors who have buyers shares of
(13:26):
credit default swaps. Then they're saying, uh, they think that
that company is gonna go under because they're paying monthly premiums.
But it's on the premise that you um that that
company is gonna go under, and there will be a
much bigger payout, yes, even more. Um, you can actually
short sell a company, driving its value down if you
(13:47):
if you own enough shares, or you can borrow enough
shares and sell them on a margin. Um. If you
have credit default swaps, it'll actually be a bigger payout
if you can drive that company into bankruptcy because you've
just created a credit event that seeing is unbelievable. Okay,
So this is where the world was teetering right now.
And in two thousand seven eight um Lehman Brothers actually
(14:07):
went down not because of subprime mortgage securities, but because
of all the credit default swaps. This huge domino effect
was triggered. A bunch of people had credit default swaps
on the subprime mortgage securities that they owned, right oops. Indeed,
so when the subprime mortgage securities went south, everybody turned
to their credit default swaps. I'm like, well, I'm I'm
(14:28):
glad I have these. Now, wait a minute, who owns
my policy? Because there's no paper trail whatsoever you have,
you track down who owns it and then hope that
they have the money to pay you. All these banks
were finding out the people that own their their um
their insurers policy, uh, didn't have the money to pay them.
The problem is is when you're writing your balance sheet.
If you have a major loss, but you have a
(14:49):
credit default swap that covers it and it pays out,
you're fine and you're staying in the red and you
probably actually made a little bit of money. If you
have a major loss and there's no credit default swap
to cover it can't be covered, then that's when your
balance she goes into I'm sorry, into the red, right,
which is the bad one? Right right? Yeah, I get that. Okay,
(15:09):
so um, that's what happened with Lehman Brothers. That's why
A I G got all of that bail out money
because they had a bunch of credit to fault swaps.
And now there's this panel that I talked about, the
independent panel that's actually gotten the value of the market
down to about twenty trillion. I wonder, however, dependent Well, yeah,
I think it's probably all revolving door and stuff like
(15:32):
they if they haven't held public office in the last
couple of years, they will work for Goldman Sax. I
think Goldmen Sex is a major player in that panel. Yeah,
well this sounds like I get it now, do you really? Yeah? Yeah? Yeah, alright,
so thanks for that, but thank you. Where does this lead?
I mean, is this uh, something's got to happen at
some point. It seems like or else it's setting us
up for even more failure economically, right, No, no, no, no,
(15:56):
most definitely. I think it's just um, it seems like
the credit of fault swaps market is being tamed. Like
I said, we've gone from sixty two trillion to twenty
trillion in just like two years. But I think it's
symptomatic of the lack of regulation and oversight that that
we've had. We have the SEC, but they don't have
any teeth in the teeth that they do have or
(16:17):
dole and and can basically just gum butter, you know. Um.
And then the fact that there's a whole over the
counter markets that are allowed to get this big without
any regulation whatsoever. I think it seems there seems to
be a pattern, Chuck, like the Great Depression was the
result of complete and total lack of oversight and regulation
(16:39):
mixed with unbridled Greek. Right, So then we come up
with things like the SEC, the FDA, all these things
that all these regulatory bodies that came out of the
Great Depression in the in the crash to prevent it
from happening again. Then we got lazy, so then this
happened again. There's going to be more regulation. The problem
is people always say, you know, pro business people always
(17:00):
a you know, regulation strangles business. I disagree. I think
the whole point to um capitalism is to make as
much money as you can as fast as you can write,
which means that no matter how many roadblocks the government
throws up, all it's doing is presenting challenges for very clever,
greedy people, and they'll always find a loophole always. Yeah.
(17:22):
So I think that's where it's leading us to more regulation.
But I don't think there's ever going to be a
saving grace where nothing like this ever happens again. Well,
when you're talking now trillion dollars, that's still such a
massive amount that it's it's kind of frightening to think
about it is, but it's doable. I think if the US, Japan,
and the UK got together and sold everything off in
(17:44):
a fire cell, we could cover it. Yeah all right,
well I get it. Thanks good, I'm feeling pretty good
about myself. Were default swaps? Ahoy? Yeah, this this was
sort of like some math kind of just goes so
far above my head. I can read it and read
it and read it and it still just doesn't sink in.
I'm like that with the algebra. I get geometry, but
(18:05):
not algebra. We should do a podcast on it and
fumble our way through that so we could. Yeah, yeah,
so there you have. It's awesome. All right, Are we
still plugging things anymore? Sure? Josh. We'll just give a
quickie plug to the blog. Alright, blog and stuff you
should know blog that we write um once a day
each and it's on the right side of the homepage.
Very nice and it's been enjoyable and that's all we
(18:27):
need to say. Yes, that is it? So then what
does that mean? Chuck's listener mail time? It is indeed,
And Josh, this one I'm really looking forward to reading.
Which one is it? This is the I ME incident?
We get a lot of these uh for those of you.
Obviously you don't know because you don't get a listener mail.
(18:47):
We have a lot of people that take us to
task on the use of I and me, Josh and I,
Josh and me and me and josh I and Josh
I seem to get it a lot more than you,
though we both do. We Yeah, So if people take
us to task and tell us that we're not being
a responsible uh with our grammar. And I got this
email from Keith and Alton, Illinois, and Keith says, I
(19:11):
just want to let you know that as a student
of linguistics, I'd like to tell you that in a
compound object e g. Send listener mail to Chuck and
I slash me, it is totally fine to use whichever
pronoun you think sounds better. I've read a link the
explanation that justifies the use of eye in a compound object,
but I won't bore you with it. My main point
is this talk in whatever way it sounds right to you,
(19:33):
while keeping in mind that certain non standard usage of
words might put off some snooty pedants. Awesome, Keith, and
he did actually send a link. I'm not gonna bore
you either. But there was a book by Steven Pinker
called The Language Instinct, and uh, I mean he sent
me a whole page where the guy basically breaks it
(19:53):
down and in the end, I'll just read the one
sentence Stephen Pinker. Really yeah, Ok, do you know him?
I just heard of him last night for the first time.
Really yeah, it's odd. How about that? So? Uh, The
last sentence of his thing says, by the logic of grammar,
the pronoun is free to have any case it wants.
I agree. I think the point of communication is to
(20:16):
get your get your idea across to somebody exactly. And
I think interchanging iron me so gets the point across. Yeah.
I think if you can get your point across with
grunts and hand gestures or if that's proper communication. Right.
And when it comes down to it, the name of
this show is not grammar. You should know, right. And
we are always the first ones to say we're not
you know, we're not perfect, so uh layoff. Yeah a
(20:39):
matter of fact, Keith, go ahead and send us your
your address because we're gonna send you a T shirt.
My man, that was cool, Thanks for coming to the rescue. Yeah, Keith,
shirt size and address, and well, thank you for having
our backs on this. So if you want to have
our backs, if you want to take us the task,
if you're a grammar Nazi or a well whatever, how
(21:00):
about we re record that part ready. So if you
want to have our backs or you want to take
us to task like the grammar Nazis that rode in Um,
just go ahead and send us an email to stuff
podcast at how stuff works dot com for more on
(21:21):
this and thousands of other topics. Does it how stuff
works dot com m brought to you by the reinvented
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