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On Friday (March 14), the Federal Reserve arranged a bailout of Wall Street's Bear Stearns. Immediately, I suspected that other financial institutions are wary that Bear can't make good on credit default swaps, complex derivatives in which one party agrees to insure another against default on a debt instrument such as a bond. I described credit default swaps and their dangers in this column Feb. 6.
In Saturday morning's editions, both the New York Times and Wall Street Journal wrote that credit default swaps may be the villains. Said the Times, "The bigger worry for hedge funds and others that do business with Bear Stearns is whether the firm will be able to honor its trades. Of particular concern are the insurance contracts known as credit default swaps." Said the Journal, "Over the last few days, some hedge funds that had bought a kind of contract called credit default swaps from Bear demanded the firm fork over cash in cases where the swaps had risen in value...When hedge funds and banks trade these swaps, the buyer of protection can require that the seller post cash or collateral against its position. Such a move helps guard against the risk of the seller defaulting on its obligation." There are $46 trillion of these swaps outstanding around the world. The total annual economic output of the world is $50 trillion. In short, this could be extremely serious.
On Friday (March 14), the Federal Reserve arranged a bailout of Wall Street's Bear Stearns. Immediately, I suspected that other financial institutions are wary that Bear can't make good on credit default swaps, complex derivatives in which one party agrees to insure another against default on a debt instrument such as a bond. I described credit default swaps and their dangers in this column Feb. 6.
In Saturday morning's editions, both the New York Times and Wall Street Journal wrote that credit default swaps may be the villains. Said the Times, "The bigger worry for hedge funds and others that do business with Bear Stearns is whether the firm will be able to honor its trades. Of particular concern are the insurance contracts known as credit default swaps." Said the Journal, "Over the last few days, some hedge funds that had bought a kind of contract called credit default swaps from Bear demanded the firm fork over cash in cases where the swaps had risen in value...When hedge funds and banks trade these swaps, the buyer of protection can require that the seller post cash or collateral against its position. Such a move helps guard against the risk of the seller defaulting on its obligation." There are $46 trillion of these swaps outstanding around the world. The total annual economic output of the world is $50 trillion. In short, this could be extremely serious.