Mailbag: Ginnaty CPA writes: A Bit on Swaps:

(Ed.note: There is a current questioning of what the exact total amount of the exposure of the "swaps" is that the governments of the world wish to stabilize. This letter is timely.)


Last night, I googled "credit swaps" and was duly impressed at the response. Wikipedia and something called "investipedia" gave numerous short succinct explanations of the vocabulary involving "credit swaps"

Some facts, credit swaps are traded on the OTC, and are unregulated. If you substitute the word "insurance" or "hedge" then I think there starts to be an understanding of what they are. In short, people holding any stock, loan, bond etc. can attempt to gain insurance from the sellers of the swaps on the principal or interest of the underlying security. That is, the sellers of the swap, warranty that if there is a problem on the underlying security they will make it up (ie. like property insurance)

What is amazing is the $ volume of swaps in existence. Depending on which article you read there was/is $45 Trillion in swaps (twice the size of the US securities market) or $250 Trillion. The only way these numbers make any sense, is that one loan, stock, bond etc is covered by multiple swaps. There just isn't that much stocks, bonds, or loans in the world. What I am suggesting apparently happens with quite regularity is that when A sells a swap, A buys a swap from B, and B buys a swap from C and so forth. The "notational" value of the swaps in my example is 3 times the original security. Unwinding this mess incase of a problem would be a nightmare.

Just as in any insurance contract, the strength in the contract lies in the seller of the contract, and whether there was adequate loss provisions established (based on adequate pricing to begin with).

The Feds and US Treasury, and E.C Community's reaction indicates they didn't think the loss provisions were adequate, and decided that it was their job to underwrite the entire world's swap industry. Good luck to them, if the 250 Trillion $ figure is correct.

Richard