Credit Default Swaps: Innovation, or Weapon of Mass Destruction?

The Shareholder Activist - Credit Default Swaps: Innovation, or Weapon of Mass Destruction?Complex financial instruments can present intimidating psychological obstacles to investors.

An investor is not expected to understand all the nuances of the investment vehicles in which he invests. Yet misguided trust can lead to disaster and threaten the viability of sound markets and companies.

Understanding how human behavior invites deception can enable you to better safeguard your investments. And no other example in recent history is as insidious as the massive fraud perpetrated with Credit Default Swaps (CDS).

Blythe Masters, at 28, became the youngest woman to achieve managing director status at J.P. Morgan. Ms. Masters was born and reared in Oxford, UK. She completed her studies at Cambridge with a B.A. in economics in 1991. She is credited with creating the financial instrument/product known as the modern credit default swap.

In essence, CDS are like an insurance policy in that it obliges the seller to compensate the buyer in the event of a default; they act as insurance on securitized debt. The buyer of a credit swap is protected and the seller guarantees the product’s credit worthiness. But the nagging question focuses on what is real, and what has true value.

CDS are a form of derivatives. A derivatives’ value is literally derived from the value of the underlying asset (or should be). Underlying assets can include: bullion, securities, livestock, currency or pretty much anything else that has genuine value.

It’s important to note that financial products are inventions designed to create, and ultimately drive markets, and make substantial money in the process. Consideration and measurement of the true value and functionality of these types of novel, exotic, products is often not clearly discernible. Then again, it can also depend on what a person believes has actual value. Intellect and emotion can easily face off in this kind of world. Financial products are people-made, not born. Many seem to have face validity but with closer examination, flaws, danger and liability abound.

Are we living in a straw, paper, cardboard shell of a world? What is the extent of CDS worldwide? How many trillions of dollars in CDS are in jeopardy? The derivative world is murky, unclear, and not well known, and massively oversubscribed.

Some analysts think that there may be as much as up to 600 trillion dollars’ worth of CDS in financial cyberspace. Other experts think that the Eurozone cannot let Greece fall because a domino wave of CDS demands and losses will ensue.

Regardless, no one party or agency has all the data at hand. There is no central clearing house for this information. The unknown is potentially lethal. Some think that it’s better to par losses to at least 50% levels up front, and keep the Greeks in the game. The theory being that a managed loss up front will protect “us” on the back end, and avoid financial Armageddon.

Was Buffet right: are CDS weapons of mass destruction, or are they innovative, valid financial devices? Buffet wrote the following to his Berkshire Hathaway shareholders as early as 2002: “Large amounts of risk, particularly credit risk, have become concentrated in the hands of relatively few derivatives dealers…The troubles of one could quickly infect the others…In our view, however, derivatives are financial weapons of mass destruction…” Ya pays your money and ya takes your choice”. To be in this game you have to have a very tough, hardy constitution.

What is always so amazing, enlightening and frightening is how so few (the 1%) can impact so many (the 99%). Perhaps it’s just as simple as: “human DNA at work again.”

Shareholders and investors need at least a rudimentary understanding of CDS, and some way of knowing if and how their company’s assets are intertwined with them.

Disclosure from their financial professionals and corporate officers is essential. At that point, shareholders can make informed decisions about their money matters. After all, fiduciary responsibility is, and should be, an unparalleled standard.

To contact Christopher Bayer directly, please email

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