Well, Jack, where are you off to?" said the man Jack met on the road one fine morning while taking his cow to market.
"I ‘m going to market to sell our cow here."
“Would you trade your nice, fat cow here for these beans,” asked the man.
Jack just laughed out loud.
“Here they are, the very beans themselves," the man pulled out of his pocket a number of strange-looking beans. Jack said he was not interested.
"Ahhh! But, you don’t know what these beans are," said the man; "if you plant them over-night, by morning they grow right up to the sky.
"Really?" said Jack.
Every morning when we open our newspapers, or fire them up on our Internet Browsers, we are living through the sad tale of some most peculiar financial ‘beans.’ Credit Default Swaps, financial hedging instruments run wild on steroids, like in Jack’s fairytale, have landed us- the entire world, it seems- into really big trouble.
Clever people who were ‘good with numbers,’ some might say too clever, aided by modern computing power using strange equations and mysterious algorithms, created exotic financial instruments, which very few people understood, then or now. Credit Default Swaps are a kind of credit derivative whose value derives from the credit risk on an underlying bond, loan or other financial asset. They once served an important purpose in the financial world; that was before speculators got hold of them and exploited both their lack of transparency and utter lack of any regulation. Warren Buffett, a true legend of the financial world, famously termed speculating with these mysterious things: “financial weapons of mass destruction.”
In Berkshire Hathaway’s annual report to shareholders in 2002, Mr. Buffett also observed that: “[t]he range of derivatives contracts is limited only by the imagination of man (or sometimes, so it seems, madmen)." Alas, but few listened.
Speculation increases the risk exponentially. An example: let’s say that Joe’s Chicken Ranch has $1 billion of outstanding debt in bonds. Based on this, there may be $10 billion of Credit Default Swap contracts outstanding—that’s ten times. Now, if Joe’s Chicken Ranch defaults and does not pay its $1 billion in debt, let’s say the recovery is 40 cents on the dollar, then the loss to investors holding those bonds on Joe’s Chicken Ranch’s debt would be $600 million—a 40% ‘haircut,’ as the Big Boys charmingly call it. However the loss to credit default swap sellers would be $6 billion—a number that simply dwarfs the actual debt in the first place. And there, truly, is the rub.
And, that’s how we got to the precipice that we peer over today, waiting to see if credit markets will unfreeze and whether the Dow and other indices will stop their freefall this week and reverse the disasters of last week. On September 23, 2008, Christopher Cox, Chairman of the U.S. Securities and Exchange Commission, estimated the worldwide Credit Default Swap market at a total of $58 trillion, stating that it was "completely lacking in transparency and completely unregulated." That means, we cannot really see where all this money value exactly is, we cannot accurately give it a value, and, criticially, nobody, anywhere, was minding the store when this giant pile of monetary value in debt grew, like Jack’s Beanstalk, from a few humble beans, to its present sky-high proportions. The Times, on Sept. 15, 2008, put it even higher: "Worldwide credit derivatives market is valued at $62 trillion." The accurate number is, at this point, anyone’s guess.
Let’s put down our coffee cups for a moment and try to get our conceptual arms around a single trillion dollars: $1,000,000,000,000–12 zeroes to the left of the decimal point. A trillion is a million million dollars. If you laid one dollar bills end to end, you could make a chain stretching from earth to the moon, and back again, 200 times (!) before you ran out of dollar bills. One trillion dollars, lined up in dollar bills, one after the other, would stretch nearly from the earth to the sun—say, 93 million miles’ distance (it varies)—a distance that light takes about eight minutes (traveling at about 186,282.397 miles per second) to travel from end to end. It would take a military jet flying at the speed of sound (a snail’s pace, at a mere 767 miles per hour!), reeling out a roll of dollar bills behind it, 14 years before it reeled out one trillion dollar bills! And, there’s only 6 ¾ billion of us on the entire planet Earth. . .
You can take another sip of your coffee now. If you have the stomach for it.