Dr. Alexander von Paleske - - The Subprime Mortgage Crisis in the US, that amounted to losses of roughly 400 Billion US Dollars worldwide, has barely been digested by the international financial markets and banks, there is already another crisis looming on the horizon: The Credit Default Swap Crisis.

This is the pessimistic forecast by George Soros, one of the worlds leading speculators, who back in 1992 forced the Bank of Britain to devalue the British Pound and made millions for his investment fund Quantum out of it. His concerns are echoed by top US financial investor Warren Buffet, who called the Credit Default Swaps a “Financial Weapon of Mass Destruction”
Is Soros an ageing speculator and alarmist, or is he someone with intimate inside knowledge of the financial markets? Let’s see

Swaps, or how to make money with bets
Credit default Swaps or CDS are derivatives, traded by banks, highly speculative, which comprise three things: Credits, insurance and bets.

Credits are the core business of banks. Bad debts are the typical risks which the banks try to minimize by carefully selecting the people and companies, to whom they give loans.

Whole departments in the banks are, or must I say were, busy to assess the risks. The banks, however, tried to have an easy way out and thus were actively searching for a different way to minimize those risks by insuring them, like a house against fire.

No insurance in the world is prepared to take up typical entrepreneurial risks, neither in the manufacturing , nor in the banking sector. So the only other way to spread the risks around would be to turn to the financial markets and trade them like futures, shares, and bonds.

However, as these instruments would not truly represent a company or a collateral for a loan, they became pure risk papers, basically a bet like a bet on a horse race.

The Birth of Credit Default Swaps (CDS)
A young Cambridge graduate by the name of Blythe Masters came up with the idea of “Insurance per Betting” which was quickly put into reality by all the leading banks. The Credit Default Swaps (CDS) were born.

No longer “due diligence” seemed to be necessary, when approving loans. In case of credit default the buyer of the risk paper had to pay. This buyer, like an insurance, is paid regular premiums by the lending bank.

As a result of this madness, 40% of all the recipients of loans are not creditworthy, according to Fitch’s rating agency. A direct result of the “insurance-mentality”. In 2002, in the early days of CDS, it was just 8%.

This whole system worked well for all parties, the banks got rid of the risks, and the “insurer” had a regular income at least for some time, as long, as the economy is not in recession and thus defaults on loans are minimal, as it was the case during the last 15 years.

The CDS became so popular, that by now the unbelievable sum of 65.000.000.000.000 US Dollars has flown into this market, double the value of 2500 leading US companies trading on the US stock market. Madness galore.

With no limitations existing in terms of how high to “insure” those loans, the inflation of these risk papers per loan has become the order of the day.

When US automotive parts company Delphi went into bankruptcy , the bad loans were amounting to 5 billion US Dollars, the CDS sums for these loans, however, amounted to 25 billion. Illegal excess-insurance under normal circumstances. The Swap market, however is ruled by different laws, mainly lawlessness. Excess-insurance has become the order of the day.

The times, they are changing
As we pointed out, as long as the bankruptcy of companies and/or the default on repayment of credits is low, the system works. However the times are changing now, and they are changing fast.

The international financial markets are in crisis, thanks to the subprime disaster, and as a result the number of bankrupt companies is dramatically on the rise, supported by the seemingly unstoppable rise of the price for crude oil. And unlike insurance companies, which in case of a mass disaster payout can turn to Re-Insurance companies, no such re-insurance exists for swaps. As a result, the first big losses from these CDS are already being reported. American International Group, AIG, the world’s largest insurer, reported a 12 billion US Dollar CDS loss. CEO Sullivan had to resign.

Swiss Re, the giant Swiss Company reported CDS losses for the last quarter only of 350 million Swiss Franc, the total losses from these risk papers amounting to 2.1 billion.

And this seems to be not the end, not the beginning of the end and not even the end of the beginning. George Soros is right, isn’t he?

Default Swaps oder: Die nächste Weltfinanzkrise rückt näher