Now let’s think about this new derivative. If a bond is paying 5 or 6% interest, and we expect it to continue paying for the next five years, we would expect to earn between 25 and 30% on the money invested over five years, assuming that the interest is paid as agreed. Even if we pay the issuer of the credit default swap a fee of 3% to assume the risk of default, we are still going to realize between 22 and 27% on the bond over five years, and – better yet, much better yet – the issuer of the credit default swap assumes the risk of default! So if the entity who issued the bond or other debt instrument defaults on its obligation to pay, we still get our entire principal back untouched, so we can immediately invest it in something else that pays a similar return. Sounds like a good deal. No, a great deal.
Calculating their investment opportunities in this way, the big commercial and investment banks in New York and London begin to realize that they had created a goose that laid golden eggs. Investments in new, relatively risky debt instruments could be protected by credit default swaps, and the bank could still come out ahead – way ahead – when compared to the risks and rewards of making money the old fashioned way, by handing out hundreds of different loans to different businesses. Since money was “easy,” borrowers were paying only about 4-5% on most business loans, and since all of these loans carried major risks of their own – a certain percentage would inevitably go bad – the big banks – Citicorp, JP Morgan Chase, Wachovia, Bank of America, Washington Mutual, Wells Fargo, and the big investment banks – analyzed the new debt instruments and convinced themselves that, when protected by credit default swaps, investing in the new debt instruments was actually safer than making loans. After all, if there was NO risk of default – if the risk of default could be offloaded onto the biggest insurance company in the world – there was nothing to worry about. Even in the worst case scenario the bank would get its principal back. That doesn’t happen with normal loans. When banks are forced to “write off” normal loans, they often get just pennies on the dollar back.
Based on calculations like these, the Western financial giants laid on the coal and steamed full speed ahead.
Logical Flaw
Now all the conditions for a Titanic disaster had been created except one. There was, as yet, no iceberg. As long as the debt instruments continued to pay interest as agreed, everything was hunky-dory. In fact, the money wizards in New York and London believed they had ushered in a new era, an era in which financial risk would be largely abolished, or at least tamped down. Very few people understood that the risks had not really been abolished, they had only been offloaded. Or that everything – the entire world financial system, and the global economy – now depended on those who had assumed the risk. If anything ever happened to AIG…
But that was unthinkable. AIG was the largest insurance company in the world. It was a company worth more than two hundred billion dollars. What could possibly happen?
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