Via Megan McArdle, a really nice explanation of derivatives, and specifically credit default swaps, written in a very basic way that even someone like me who knows nothing about economics can understand.
On a side note, the author of that piece is rather cynical about the integrity of the media’s reporting on the financial crisis:
For example, consider the obligations of 3 friends: A, B and C. A owes B $2; A owes C $3; B owes A $4; B owes C $5; C owes A $2; and finally C owes B $6.
[...]
That complex web of relationships between A, B, and C, reduced to 1 transaction worth $1. Yet, the media would have certainly reported a cataclysmic 2 + 3 + 4 + 5 + 2 + 6 = $22 in total debts.
[...]
The press loves a spectacle. There’s a good reason for this: panic increases paranoia, which increases the desire for information, which increases their advertising revenues. Thus, the press has an incentive to exaggerate the importance of the events they report.
As an example, he cites a Reuters story that proclaims in its headline: “Lehman CDS sellers lose $365 bln after auction.” Although if you read the article, it says:
Based on those estimates, the amount of insurance paid out would equal $365.5 billion, CreditSights analyst Brian Yelvington said in a report. However, “net positions are likely to be much lower,” he said.
How much lower? Well, Reuters reported twelve days later: “Payment on Lehman CDS only around $5.2 bln.” Explained:
Analysts said these concerns were misplaced, however, because large players in the market, such as dealers and some hedge funds, had both bought and sold protection, subsequently taking both gains and losses on Lehman’s default that offset each other.
October 29th, 2008 - 11:56 am
I recently had to learn all about CDS for a case, and the first 2 or 3 people who tried to explain it to me failed miserably. It’s really quite sad.