--

Why They Matter

Unlike auto or home insurance, CDS's are not regulated. They are traded from one investor to another on a regular basis. In many times a CDS may be traded 15 to 20 times from it's origin. At the present time, there are about 50 Trillion dollars worth of these types of derivatives circulating around the world. In many cases, the company that initially took out the derivative has no idea who presently owns it. The scary thing is that because these are not regulated, no one really knows if the present holders of the derivatives has the money to pay them out. Some of the companies that now hold them are on the verge of bankruptcy. If they do go bankrupt, they have no way of paying them out.

Imagine if you took out fire insurance on your home. Imagine that this policy was sold 15 times around the world and is now owned by a bank in Iceland (which bought a lot of these). Now that bank is bankrupt. Your house burns down. You want the money for your insurance. You go to claim your insurance but the insurer no longer exists. You lose.

Say you're a bank with 20 Billion dollars worth of bad mortgages, which you have insured. Now you were smart and insured them. So now you go to claim your insurance policy, which is held by a bank in Finland! Well, sorry Mr. Banker... you lose.

Now, you just lost 20 Billion dollars and that puts you in a state of illiquidity, meaning that you don't have any money. So people get wind of this and feel your bank may fail. So they take out their money... called a bank run. Now you're almost insolvent. You must borrow money but no one will give it to you because you're insolvent. They can't loan you money because you're a bad risk and the insurance they would pay on you is too high. So you go bankrupt. Unfortunately, your bank also holds CDS's for other banks and corporations. ... oh oh... you can see how this now starts to spiral downward.

------------------------------------...

The Really Scary Part

During the early part of the 2000's the derivative market was very small. However, financial heads in the US government liked them. The largest supporter of them was Allan Greenspan, the guy who was head of the FED and most powerful banker in the world. He liked them because it allowed banks to take more risk, since they could insure all their risks. They could give almost anyone credit, almost any business credit, knowing that they'd be insured. Sure, it meant that higher risk insurees would pay higher interest rates but to those people, it didn't matter because the housing market was booming and they would make that back after buying and selling a few houses.

As long as housing and the economy in general was going up, few people were defaulting on their payments and as such, CDS's were a great buy. You could buy this insurance policy and since hardly anyone was defaulting, you just kept getting payments for it. It was like a very high interest bond.

Unfortunately, they bond and mortgage ratings agencies, which are paid by the banks, had it in their own interest to rate the bonds and mortgages as lower risk than they really were. This would be like giving an AA rating to a driver with 3 drunk driving convictions in the last 3 years.

In fact, because these things have changed hands so many times, no one really knows how fairly the ratings are in the underlying mortgages and bonds. The only thing anyone really knows is that they're higher than they should be.

Keep in mind that most municipal and government bonds get very high ratings, since the countries and cities behind them are generally stable. However, now we're starting to see that some of those places are not so stable. ICELAND is now on the verge of bankruptcy. California is also facing trouble. This is just the start. What if Portugal falls next. It can spread right through Europe. In fact, no one can say that the mighty old USA, with their 10 Trillion dollar debt is safe.

----------------------------------

The REALLY REALLY Scary Part?

In order to start saving this whole mess from spreading, Europe and the USA have been dumping unprecedented amounts of money into their banks. They are now guaranteeing solvency of their banks and actually buying them up.

That puts these governments on the hook for TRILLIONS and TRILLIONS in credit default swaps. If the credit default swap market collapses, it is probable that the US debt could explode to 20 Trillion or more, which could make the US dollar worth half or less, which would then make their debt unpayable adding to the derivative mess causing a financial collapse in the world that would be greater than ever in history. Currencies around the world would become worthless. Pricing would be adjusted by the hour in stores.

In this very pessimistic case the only currency that would have any value would be GOLD. If you had 5% of your money in gold, it would become worth more than all the rest of your money in dollars.

What is the likelihood of this happening? Probably greater than your house burning down. Yet you have insurance on your house. So get a little gold :) Gold is insurance against financial armaggedon.

It is unlikely that the doomsday thing will happen but something less but also very devastating is very likely. As for a time frame for this.. no one can say for sure. I think sometime in the next year. We might get a bounce in the markets along the way as the bandaids that central banks are putting on has some effect, however when these CDS's really start to hit the fan, the markets will crash fast and hard. So do take precautions. Buy Gold.

Diabullic