Credit default swap tsunami approaches

house of cards
Major insurance company AIG said yesterday they can no longer quantify what their credit default swaps are worth, this after their auditors concluded there was “material weakness” in the way AIG was doing their valuations.

Sounds like the early days of the Enron implosion, doesn’t it? Except that the numbers are much bigger. A CDS is a way of buying insurance on bonds without calling it insurance because, well, only insurance companies are allowed to sell insurance.

Consider GM. The market cap of GM is $15 billion or so. There are about $1 trillion in credit default swaps bet on the success or failure of GM. It is virtually impossible for this to be hedged because there is not $1 trillion in GM bonds available as collateral.

Soon, probably quite soon, there will be a major counterparty collapse and this will triggering a cascade of defaults. When AIG says they can no longer value their CDS, this in effect means the CDS are worthless.

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