I realize many people don't really understand what a CDS (Credit default swap) or any other swap is and why they are so critical to the bailout and the cost of it.
What is a swap?
First, what isn't it?
Ok, a swap is not a right to anything physical - i.e., it is not a mortgage on a house or owning part of a company's equity.
Ok, what is it?
A swap is a bet - plain, pure and simple. It is a bet on whether something will be worth more or less than a given amount on a specified date. You say what?
Ok, let's look at a Dow Jones swap (just an example). Let's say I want to sell a December 20, 2008 swap on the Dow Jones average at 9500 points at a dollar a point. What does this mean?
This means that I agree to pay the buyer $1 per point that the Dow Jones average settles above 9500 at the end of day December 20, 2008. I would receive $1 per point that it settles below 9500.
Now, let's assume I do 1 million lots.
If the Dow Jones settles at 9000 points on December 20, 2008, I would be owed $500 million.
So what does this mean for the bailout?
Ok, let's go back to CDSs. OK, let's say I am Lehman Brothers. The rumors are that Lehman had over $600 BILLION in CDSs on the books. Let's assume they were set at $1 per unit or 600 billion units.
Now, if the markets for CDSs have dropped 75%, that means that Lehman's customers are expecting they will be owed about $450 billion if nothing changes.
OK, so what?
Well, the standard contract for these type of products is called an ISDA - an International Swap Dealers Agreement. Again, so what? Well, the standard document has a credit annex - describing how credit between the parties is handled. The credit annex gives the party that would be owed money to request collateral in the event the amount potentially owed - under mark-to-market accounting - exceeds a certain amount. Oh, now we get interesting.
So, if Lehman was leveraged 30 to 1 and the CDS exposures ran to $450 billion, it is likely the counterparties started to get nervous. If Lehman had 30 to 1 leverage, the bank would hold $20 billion against that $600 billion exposure. If the mark-to-market got to $450 billion, the collateral would equal 22.5 times the equity held againts the exposure. That is the cause of the contraction.
So, what does the bailout do?
It will allow the US Treasury to buy that $600 billion at $1 per unit. This means that the bank takes $450 billion of losses off the books. But since the money on that swap is not due until December 20 means that no money need change hands. The Treasury could buy multiples of the $750 billion of the "bailout" without spending a dollar.
And since the Treasury now owns the swap, the counterparties feel confident that the US will cough up the $450 billion when owed. This means that collateral will go to zero - for the present.
But that circles back to the "taxpayers" may come out even by holding to maturity. The problem with this is that the swap isn't about what the underlying asset is worth. It is about the value the product sells for on the date the swap settles. If the value of these swaps does not recover to the orignal value at the time the swap was sold - real estate or mortgage values in 2004 - by the time the swap settles, the taxpayer loses. Let's say the Treasury buys $4 Trillion in swaps at "purchase price" without spending a dollar. Let's assume the mark-to-market loss is $3 Trillion. If the market recovers 100%, the Treasury only has to pay out $2 Trillion on the settlement date.
What does this mean?
Changing mark-to-market will nothing except allow the Treasury to hide the risk of what they are buying. Why? Because the ISDA will still allow the counterparty to rely on current market prices for collateral calls - which means that any toxic swaps left on the bank books will continue to contract the credit markets. At an estimated $50 trillion of CDS and other swap exposures on the investment bank books, the Treasury is going to own a lot of risk to get the credit markets back on track.
This has been an attempt to explain a very difficult concept.