There's a good article from Wharton here 2005 on Delphi that shows the magnitude of the leverage that derivatives put into the market. The problematic issue is that so many funds own some of these instruments - so the exposure to mainstreet (us) is significant.
When Delphi filed for bankruptcy October 8, investors had to start assessing their losses on more than $2 billion in the auto parts maker's bonds, which have recently traded at around 60% of their face value. As bad as that is, there is more. Looming over the market like an invisible and unpredictable giant is an estimated $25 billion in credit derivatives, a form of insurance whose value is directly linked to the ups and downs of Delphi debt.
So, a $2 billion loss triggers an obligation of $25 billion in credit derivatives - for a total impact of $27 billion!
In recent years, many credit default swaps have been assembled into baskets and traded as indexes, much the way stocks can be traded through S&P 500 index funds. This allows investors to use credit default swaps to bet on broad changes in credit markets -- betting that default rates will rise or fall, for example.Banks are both the biggest buyers of CDS protection and the biggest sellers, using them to reduce their risk exposure to companies to whom they have lent money, thus reducing the capital needed to satisfy regulatory requirements. Other big buyers are securities firms and hedge funds, while re-insurers, insurers and securities firms are the other large sellers.
In recent years credit default swaps have been bundled together to create collateralized debt obligations (CDOs). Typically, a CDO contains swaps from more than 100 companies. Once put together, the CDO is sliced into a several tranches, which are then sold separately. At one extreme is the high-risk, high-yield slice. Owners of these get a disproportionately large share of the income flowing into the CDO. But they also are first to suffer the losses from any companies that default. At the other extreme is a safe, low-yield tranche, with one or two other tranches occupying the middle.
Short Squeeze
Rosen estimated there are $25 billion in credit derivatives riding on $2 billion in Delphi bonds. Just as any catastrophe triggers insurance claims, Delphi's problems mean credit default swap sellers owe payments to the buyers who took out the insurance. Many contracts require the insured party to turn the underlying bonds over to the insurer when the payment is received, much as an insurance company may take possession of a wrecked car upon paying a claim.
Insured parties that don't have the bonds in their portfolios can buy them through the market to satisfy this obligation. But because of leveraging, there may not be enough bonds to go around. The escalating demand can cause a short squeeze, Rosen said, that would drive up the bonds' price and cause spiraling expenses for those desperate to get the bonds, possibly forcing them to sell other assets to come up with more cash.
Hedge-fund investors take their chances with their eyes open, and nobody else cares much if some of them get burned. But ripple effects do sometimes swamp the innocent, too. That was the big worry when Long-Term Capital Management's bets went sour.
According to Ramaswamy, it is unlikely that trouble related to a single company like Delphi will spill over to the broad markets, but he said it would be worrisome if a large number of companies ran into serious difficulties. And Rosen noted there is a lot of dry tinder on the forest floor -- a mushrooming issuance of low-rated, high-risk debt. "I will be shocked if we don't see a significant rise in default rates over the next 18 months," he said.
It is my sincere wish that every citizen in our country could read your post and understand its implications fully.
It is so sad to drive by the restaurants this evening and see the parking lots full as people charge their way into oblivion - without having a clue what is about to hit them.