Oct
15
2008

The “Smell Test” – Credit Default Swaps Explained

There are two types of “smell tests.”[1]

Smell test: Good or bad investment?

Smell test: Good or bad investment?

The first type of smell test is a very literal smelling test.  A bachelor smells an article of clothing to determine whether said article of clothing could be worn on that day around the people said bachelor anticipates being near.  Doesn’t smell bad?  Put it on!  Smells bad?  Turn it inside-out and put it on!

The second type of “smell test” is where you evaluate a situation based upon your gut reaction.

Some blame “credit default swaps” for our current financial crisis.  (Disclaimer: I have no special knowledge about finance – I just listen to NPR constantly).  So, here’s what happened:

  1. Investors (Company A) buy up lots of sub-prime mortgages through a trust.
  2. Company A, looking to make money as investors are wont to do, sell pieces of the trust as if they were stocks.
  3. Other people (Company B), having seen these investors buying up risky sub-prime mortgages, have a great idea – “credit default swaps.” (Or, as they are known on NPR, “CDS’s”).
  4. Company B promises Company A that, in exchange for a very reasonable sum, if one of the people living in one of those sub-prime mortgage homes stops paying that mortgage, Company B will be responsible for that lost asset and income.
  5. Company B tells Company A that this wonderful product is called a “credit default swap,” and that it is definitely-not-insurance.  In fact, its significantly cheaper than buying insurance.
  6. Since Company B is not selling insurance they don’t have to be regulated like insurance.  Insurance companies are required to hold “reserves.”  A “reserve” is simply money that can’t be spent in case an insurance company be required to honor some of their insurance policies.
  7. There are so many Company A‘s looking to hedge their bets that all the Company B‘s CDS’s are selling like hotcakes.  The people that own Company B are so pleased with themselves that they don’t really bother with reserves.
  8. In a few years those sub-prime mortgages with adjustable rates were finally out of their introductory rate period – and thousands of people start defaulting on their loans.
  9. Company A‘s portfolio is now worthless, but they are very happy they had so much foresight as to take out not-insurance policies with Company B.
  10. Company B‘s doesn’t pick up the phones.  Their offices are boarded up, the e-mails bounce back, and Company A stops getting Christmas cards from Company B.

The problem is that Company B went out of their way to invent something that was definitely-not-insurance so they wouldn’t be regulated like insurance companies.  Obviously, Company B didn’t use the “smell test” when they designed their product.  If they had, they would have charged more or kept more money in reserve.

Unfortunately, Company A didn’t use the “smell test” either when shopping around for a way to insure their investments.  You don’t insure your home, car, or life with the cheapest or newest insurance company.  You choose a company that has been around a while and charges reasonable rates for reasonable risk.

When people stop performing the “smell test” $62,000,000,000,000.00 evaporates overnight.

  1. Photo courtesy of Charles & Clint.  Photo editing: All me! []

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