Bill Gross of giant bond management company PIMCO says losses on credit default swaps could reach $250 billion based on historical default rates.
To put that number in perspective, many Street estimates ascribe similar losses to subprime mortgages, a derivative category substantially distinct from CDS insurance.
With CDS, a bond issuer sells risk to the buyer who agrees to make good on defaults above a certain level in return for an income stream. They can’t call it insurance because only insurance companies can sell insurance, but that’s what it is. But insurance companies and banks are required to have cash reserves to meet black swan events, buyers of CDS are not. He calls this the shadow banking system, a huge, unregulated entity now filled with hidden icebergs of risk and lurking catastrophe.
“Buyers of protection” will be on the other “winning” side, but the point is that as capital gains and capital losses slosh from one side of the shadow system’s boat to the other, casualties and shipwrecks are the inevitable consequence.
This also spells, in his view, an end to the neocon style of capitalism.
Market based, regulation-lite American style capitalism, seemingly so ascendant after the dot.com madness nearly a decade ago, has met its match with the subprimes and the poorly structured and supervised derivative conduits of today’s markets.