WEBVTT 00:00:00.000 --> 00:00:03.220 Imagine you could legally buy fire insurance 00:00:03.220 --> 00:00:05.780 on your neighbor's house. Like not your house, 00:00:06.219 --> 00:00:08.160 your neighbors. Which, you know, immediately 00:00:08.160 --> 00:00:10.300 gives you a pretty massive financial incentive 00:00:10.300 --> 00:00:13.119 to just sit on your porch and actively hope their 00:00:13.119 --> 00:00:17.019 kitchen catches fire. Exactly. And in 2008, the 00:00:17.019 --> 00:00:19.539 global financial system did exactly that. If 00:00:19.539 --> 00:00:21.940 you hear about the 2008 crash and your brain 00:00:21.940 --> 00:00:25.679 instantly floods with Wall Street jargon like 00:00:25.679 --> 00:00:28.719 derivatives and subprime mortgages, you are definitely 00:00:28.719 --> 00:00:31.480 not alone. Yeah, it's this infamous financial 00:00:31.480 --> 00:00:34.200 boogeyman. And the terminology in the financial 00:00:34.200 --> 00:00:37.479 world is often designed to feel... Now, kind 00:00:37.479 --> 00:00:39.799 of impenetrable. Right. It keeps the actual mechanics 00:00:39.799 --> 00:00:42.179 hidden. Exactly. It hides behind this wall of 00:00:42.179 --> 00:00:44.020 complexity, which makes people assume it's just 00:00:44.020 --> 00:00:45.740 too difficult to understand. Which is why our 00:00:45.740 --> 00:00:47.939 mission for this deep dive is to cut right through 00:00:47.939 --> 00:00:50.479 that dense jargon. We are pulling from a really 00:00:50.479 --> 00:00:53.240 comprehensive Wikipedia article detailing the 00:00:53.240 --> 00:00:55.719 credit default swap, the CDS. And we're going 00:00:55.719 --> 00:00:59.079 to track how what started as a, honestly, a genuinely 00:00:59.079 --> 00:01:01.960 clever risk management tool mutated into this 00:01:01.960 --> 00:01:04.659 multi -trillion dollar global casino. A casino 00:01:04.659 --> 00:01:07.340 that nearly broke the world economy. OK, let's 00:01:07.340 --> 00:01:10.620 unpack this. What fundamentally is a credit default 00:01:10.620 --> 00:01:14.359 swap? So at its most basic mechanical level, 00:01:14.579 --> 00:01:18.159 a CDS is just a financial contract. It's an agreement 00:01:18.159 --> 00:01:22.219 where the seller of the CDS compensates the buyer 00:01:22.219 --> 00:01:26.239 if a specific debt like, say, a massive corporate 00:01:26.239 --> 00:01:29.079 bond issued by a company. goes into default. 00:01:29.459 --> 00:01:31.959 OK, so I'm the buyer. I'm paying for this protection. 00:01:32.280 --> 00:01:35.500 Right. You, the buyer, make these regular ongoing 00:01:35.500 --> 00:01:38.299 premium payments. And in the industry, they call 00:01:38.299 --> 00:01:41.180 that payment a spread. A spread. OK. Yeah. And 00:01:41.180 --> 00:01:43.159 in exchange for paying that spread, you get a 00:01:43.159 --> 00:01:45.579 massive payout if the underlying company fails 00:01:45.579 --> 00:01:48.099 to pay its debts. See, the source material constantly 00:01:48.099 --> 00:01:50.140 compares this to insurance. And I get why. It 00:01:50.140 --> 00:01:51.920 looks like insurance. You know, it acts like 00:01:51.920 --> 00:01:54.019 insurance. You pay a premium. A bad event happens. 00:01:54.079 --> 00:01:55.719 You get a payout. Right. It sounds identical. 00:01:55.980 --> 00:01:57.799 But going back to that neighbor's house analogy, 00:01:58.040 --> 00:02:00.060 I really have to push back on calling it insurance, 00:02:00.219 --> 00:02:02.680 because in the real world, you cannot legally 00:02:02.680 --> 00:02:04.819 insure something you don't own. Yeah, you definitely 00:02:04.819 --> 00:02:07.530 can't. Like, if I try to buy a policy on a stranger's 00:02:07.530 --> 00:02:09.870 car, the insurance company will literally laugh 00:02:09.870 --> 00:02:11.949 me out of the building. It's a concept called 00:02:11.949 --> 00:02:14.069 insurable interest. Right, which is designed 00:02:14.069 --> 00:02:18.030 specifically to prevent you from having a financial 00:02:18.030 --> 00:02:20.849 motive to go slash their tires. Exactly. But 00:02:20.849 --> 00:02:23.770 in the world of high finance, with the CDS, you 00:02:23.770 --> 00:02:26.560 can absolutely insure debt you don't own. And 00:02:26.560 --> 00:02:29.099 what's fascinating here is just how common that 00:02:29.099 --> 00:02:31.740 exact practice became. Because the source notes 00:02:31.740 --> 00:02:34.280 that these specific contracts, where the buyer 00:02:34.280 --> 00:02:36.280 doesn't even hold the underlying corporate bond, 00:02:36.719 --> 00:02:39.199 they are insuring they have a specific name. 00:02:39.460 --> 00:02:42.439 They're called Naked CDS. Naked CDS. And how 00:02:42.439 --> 00:02:43.900 much of the market are we talking about here? 00:02:44.139 --> 00:02:46.199 Well, they are estimated to make up as much as 00:02:46.199 --> 00:02:49.000 80 % of the entire credit default swap market. 00:02:49.219 --> 00:02:52.319 Wait. 80%. So 80 % of this market is essentially 00:02:52.319 --> 00:02:55.039 placing bets on a neighbor's house burning down. 00:02:55.199 --> 00:02:57.800 Yeah. The vast majority of the market is entirely 00:02:57.800 --> 00:03:00.400 decoupled from the actual asset. And that actually 00:03:00.400 --> 00:03:02.379 brings up the critical legal distinction of why 00:03:02.379 --> 00:03:04.159 this isn't classified as an insurance product. 00:03:04.219 --> 00:03:06.979 Because it's a bet. Exactly. And because it avoids 00:03:06.979 --> 00:03:09.699 that legal definition of insurance, the sellers 00:03:09.699 --> 00:03:12.340 of these contracts are not required by law to 00:03:12.340 --> 00:03:14.960 maintain cash reserves to cover their potential 00:03:14.960 --> 00:03:17.639 payouts. Hold on a second. If I write a normal 00:03:17.639 --> 00:03:20.879 insurance policy, regulators are breathing down 00:03:20.879 --> 00:03:23.280 my neck. They're making sure I have cash in the 00:03:23.280 --> 00:03:26.740 vault based on like strict actuarial science. 00:03:27.060 --> 00:03:29.199 Right, of course. You're telling me Wall Street 00:03:29.199 --> 00:03:31.659 firms were writing billion dollar policies and 00:03:31.659 --> 00:03:33.780 essentially just operating on the honor system? 00:03:34.039 --> 00:03:36.419 Pretty much. I mean, they manage their risk primarily 00:03:36.419 --> 00:03:39.000 just by hedging with other CDS deals. They create 00:03:39.000 --> 00:03:42.300 this massive web of offsetting bets rather than 00:03:42.300 --> 00:03:44.039 holding hard capital. They didn't have to keep 00:03:44.039 --> 00:03:46.060 the cash in the vault. That sounds incredibly 00:03:46.060 --> 00:03:49.159 dangerous. Oh, it was. That specific lack of 00:03:49.159 --> 00:03:51.919 a reserve requirement is the exact structural 00:03:51.919 --> 00:03:54.400 flaw that will become a catastrophic problem 00:03:54.400 --> 00:03:56.430 later on. Okay if you're listening to this and 00:03:56.430 --> 00:03:58.789 wondering why on earth anyone would invent an 00:03:58.789 --> 00:04:00.629 instrument where you can bet on debt you don't 00:04:00.629 --> 00:04:03.150 own without keeping reserves to pay off the bet 00:04:03.629 --> 00:04:06.250 We really have to travel back to 1994 to see 00:04:06.250 --> 00:04:08.889 its original purpose. We traveled to J .P. Morgan 00:04:08.889 --> 00:04:11.530 and specifically an economist there named Blythe 00:04:11.530 --> 00:04:15.530 Masters. Right. So in 1994, the oil giant Exxon 00:04:15.530 --> 00:04:18.910 is facing a massive crisis. The Exxon Valdez 00:04:18.910 --> 00:04:21.569 oil spill had occurred and they were staring 00:04:21.569 --> 00:04:24.389 down the barrel of five billion dollars in punitive 00:04:24.389 --> 00:04:27.029 damages. They needed cash immediately. Right. 00:04:27.410 --> 00:04:29.930 J .P. Morgan stepped up and gave Exxon a four 00:04:29.930 --> 00:04:33.000 point eight billion dollar credit line. But loaning 00:04:33.000 --> 00:04:36.819 $4 .8 billion to one single company is an enormous 00:04:36.819 --> 00:04:39.720 amount of concentrated risk. Huge risk. If Exxon 00:04:39.720 --> 00:04:42.839 went bankrupt fighting those legal battles, JP 00:04:42.839 --> 00:04:45.480 Morgan would take a lethal hit. They needed a 00:04:45.480 --> 00:04:48.259 way to offload that risk without actually canceling 00:04:48.259 --> 00:04:50.120 the loan. And if we connect this to the bigger 00:04:50.120 --> 00:04:52.399 picture, you have to look at the banking regulations 00:04:52.399 --> 00:04:54.819 governing JP Morgan at the time. Under the Baselai 00:04:54.819 --> 00:04:57.699 regulations, banks were required to hold 8 % 00:04:57.699 --> 00:04:59.980 of their total loan amounts in reserve. OK, so 00:04:59.980 --> 00:05:01.720 that's capital they simply couldn't touch or 00:05:01.720 --> 00:05:03.860 invest. Exactly. It's just sitting there. Yeah. 00:05:03.959 --> 00:05:05.800 So JP Morgan's team went to the European Bank 00:05:05.800 --> 00:05:08.319 of Reconstruction and Development, the EBRD, 00:05:08.500 --> 00:05:10.980 and JP Morgan offered to pay them a regular fee. 00:05:11.100 --> 00:05:14.040 Like an insurance premium. Right. In exchange, 00:05:14.560 --> 00:05:18.170 if Exxon defaulted on the loan, the EBRD would 00:05:18.170 --> 00:05:21.149 have to cover the loss. So JP Morgan gets to 00:05:21.149 --> 00:05:23.250 keep their client, but they strip the risk away 00:05:23.250 --> 00:05:26.389 and just hand it to someone else. Yes. And by 00:05:26.389 --> 00:05:29.050 offloading that default risk to a third party, 00:05:29.589 --> 00:05:31.670 JP Morgan was technically no longer carrying 00:05:31.670 --> 00:05:33.730 that risk on their books. That meant they didn't 00:05:33.730 --> 00:05:36.129 have to hold that 8 % in reserve anymore. Oh, 00:05:36.129 --> 00:05:38.529 wow. So they freed up regulatory capital to go 00:05:38.529 --> 00:05:41.839 out and make entirely new loans. Exactly. And 00:05:41.839 --> 00:05:44.000 regulators initially praised this. They viewed 00:05:44.000 --> 00:05:47.139 it as a brilliant safe way to disperse risk broadly 00:05:47.139 --> 00:05:50.019 across the financial system. The logic was that 00:05:50.019 --> 00:05:52.259 a single corporate collapse wouldn't take down 00:05:52.259 --> 00:05:54.500 a major bank. Here's where it gets really interesting, 00:05:55.019 --> 00:05:57.000 because finding an institution like the EBRD 00:05:57.000 --> 00:06:00.439 that can swallow $4 .8 billion of risk all at 00:06:00.439 --> 00:06:03.139 once is, well, incredibly difficult. Yeah, there 00:06:03.139 --> 00:06:05.550 aren't many entities with pockets quite that 00:06:05.550 --> 00:06:08.930 deep. So in 1997, JP Morgan invents a proprietary 00:06:08.930 --> 00:06:11.790 product called Bistro, Broad Index Securitized 00:06:11.790 --> 00:06:14.430 Trust Offering. Bistro is really the turning 00:06:14.430 --> 00:06:16.930 point here. It was the first example of what 00:06:16.930 --> 00:06:19.649 we now call the synthetic collateralized debt 00:06:19.649 --> 00:06:23.769 obligation, the synthetic CDO. They didn't just 00:06:23.769 --> 00:06:27.689 pass one loans risk to one buyer, they securitized 00:06:27.689 --> 00:06:30.360 the risk itself. Let's break down how that actually 00:06:30.360 --> 00:06:33.379 works mechanically. Because securitizing risk 00:06:33.379 --> 00:06:35.500 sounds like a phrase designed to put people to 00:06:35.500 --> 00:06:38.019 sleep. It really does. Think of Bistro like a 00:06:38.019 --> 00:06:41.519 cascading waterfall of risk. JPMorgan takes the 00:06:41.519 --> 00:06:43.660 default risk of hundreds of different corporate 00:06:43.660 --> 00:06:46.660 loans and bundles them together. Then they chop 00:06:46.660 --> 00:06:49.060 that bundle into different tiers or tranches 00:06:49.060 --> 00:06:52.079 and sell those to investors. Right? The investors 00:06:52.079 --> 00:06:54.720 at the very bottom of the waterfall get the highest 00:06:54.720 --> 00:06:57.519 payout, the best interest rate. But if any of 00:06:57.519 --> 00:06:59.879 those underlying companies default, those bottom 00:06:59.879 --> 00:07:02.199 investors are the first ones to get soaked and 00:07:02.199 --> 00:07:04.220 lose their money. And then the investors at the 00:07:04.220 --> 00:07:06.279 top of the waterfall get a much lower return, 00:07:06.639 --> 00:07:08.480 but they only lose their money if almost every 00:07:08.480 --> 00:07:10.939 single company in the bundle goes bankrupt. Exactly. 00:07:11.079 --> 00:07:13.740 And the key word there is synthetic, because 00:07:13.740 --> 00:07:15.980 in a traditional mortgage -backed security, you 00:07:15.980 --> 00:07:20.240 are buying actual pieces of real loans. In a 00:07:20.240 --> 00:07:23.199 synthetic CDO like Bistro, no actual loans are 00:07:23.199 --> 00:07:26.019 changing hands. It's just pure risk being traded. 00:07:26.100 --> 00:07:28.060 Right. The investors are just selling credit 00:07:28.060 --> 00:07:31.040 default swaps on that bundle of loans. They're 00:07:31.040 --> 00:07:33.560 providing the insurance. This allowed banks to 00:07:33.560 --> 00:07:35.680 distribute risk to hundreds of smaller investors 00:07:35.680 --> 00:07:38.839 globally rather than relying on one massive partner. 00:07:39.040 --> 00:07:42.199 But wait, if this was primarily a tool for big 00:07:42.199 --> 00:07:45.220 banks to safely manage their lending risk, how 00:07:45.220 --> 00:07:47.939 did it spiral into a 62 trillion dollar retail 00:07:47.939 --> 00:07:50.319 market? Did the rules change? Oh, the environment 00:07:50.319 --> 00:07:52.459 changed dramatically in the year 2000. There 00:07:52.459 --> 00:07:55.120 was this law called the Commodity Futures Modernization 00:07:55.120 --> 00:07:58.120 Act. This U .S. law specifically stated that 00:07:58.120 --> 00:08:00.120 credit default swaps were neither futures nor 00:08:00.120 --> 00:08:02.399 securities. Meaning what, exactly? That meant 00:08:02.399 --> 00:08:04.360 they were entirely exempt from regulation by 00:08:04.360 --> 00:08:06.959 both the SEC and the CFTC. They were legally 00:08:06.959 --> 00:08:09.560 allowed to exist in the shadows. They were traded 00:08:09.560 --> 00:08:11.800 privately over the counter between institutions 00:08:11.800 --> 00:08:15.000 without any regulatory oversight at all. So the 00:08:15.000 --> 00:08:17.720 guardrails completely come off. We move from 00:08:17.720 --> 00:08:22.399 an unregulated market in 2000 to a $62 .2 trillion 00:08:22.399 --> 00:08:25.399 notional value market by the end of 2007. It's 00:08:25.399 --> 00:08:27.720 massive growth. To understand how it got that 00:08:27.720 --> 00:08:30.399 big, our source breaks down three main uses. 00:08:30.800 --> 00:08:33.720 Hedging, arbitrage, and speculation. We covered 00:08:33.720 --> 00:08:36.600 hedging with the Exxon example. A bank makes 00:08:36.600 --> 00:08:39.419 a loan and buys a CDS to protect itself. And 00:08:39.419 --> 00:08:41.299 a massive benefit of doing this synthetically. 00:08:41.519 --> 00:08:44.279 is preserving the client relationship. Oh, right. 00:08:44.539 --> 00:08:47.480 Because if I loan a company money and then immediately 00:08:47.480 --> 00:08:50.120 turn around and sell their loan to a rival bank... 00:08:49.950 --> 00:08:51.929 The client is going to assume I don't trust them. 00:08:52.269 --> 00:08:55.009 Exactly. The CDS lets the bank offload the risk 00:08:55.009 --> 00:08:57.370 in secret without the borrower ever knowing. 00:08:57.610 --> 00:09:00.009 Sneaky, but effective. Very. And that desire 00:09:00.009 --> 00:09:02.690 to quietly manage risk spawned an entirely different 00:09:02.690 --> 00:09:05.169 strategy for traders capital structure arbitrage. 00:09:05.490 --> 00:09:08.129 This relies on a mechanical relationship between 00:09:08.129 --> 00:09:10.409 a company stock price and its CDS spread. OK, 00:09:10.490 --> 00:09:12.710 think of them like a seesaw. If a company is 00:09:12.710 --> 00:09:15.029 thriving, investors buy its stock, driving the 00:09:15.029 --> 00:09:17.429 price up. Right. And because the company is doing 00:09:17.429 --> 00:09:20.870 well, the risk of bankruptcy drops. So the cost 00:09:20.870 --> 00:09:23.769 to ensure its debt, the CDS spread, should naturally 00:09:23.769 --> 00:09:26.269 go down. Stock goes up, CDS spread goes down. 00:09:26.549 --> 00:09:28.950 But the market isn't always perfectly efficient. 00:09:29.370 --> 00:09:31.730 Sometimes one side of the seesaw gets stuck. 00:09:31.789 --> 00:09:34.149 And that is exactly the mechanism they exploit. 00:09:34.850 --> 00:09:37.129 An arbitrager might notice that a company's stock 00:09:37.129 --> 00:09:39.789 plummeted on terrible earnings news, but the 00:09:39.789 --> 00:09:42.610 CDS market hasn't reacted yet. The insurance 00:09:42.610 --> 00:09:45.559 is still cheap. So they swoop in. Right. The 00:09:45.559 --> 00:09:47.840 trader can buy the cheap CDS protection, and 00:09:47.840 --> 00:09:50.419 perhaps short the stock, exploiting that temporary 00:09:50.419 --> 00:09:53.440 delay in the seesaw to lock in a profit when 00:09:53.440 --> 00:09:56.220 the CDS spread inevitably rises to match the 00:09:56.220 --> 00:09:58.840 new reality. Okay, so hedging is risk management. 00:09:59.100 --> 00:10:01.919 Arbitrage is basically exploiting math. But then 00:10:01.919 --> 00:10:04.450 we get to the third use. speculation. And this 00:10:04.450 --> 00:10:07.409 brings us back to those naked CDS. The casino 00:10:07.409 --> 00:10:10.070 aspect. Exactly. Look at the mechanics of shorting 00:10:10.070 --> 00:10:11.990 a company's credit this way. You don't have to 00:10:11.990 --> 00:10:13.669 borrow a physical bond. You don't have to put 00:10:13.669 --> 00:10:15.970 up millions of dollars to buy a bond. You just 00:10:15.970 --> 00:10:18.009 sign a contract promising to pay a quarterly 00:10:18.009 --> 00:10:21.009 premium. And if that company goes bankrupt, you 00:10:21.009 --> 00:10:23.299 make tens of millions of dollars. If you're listening 00:10:23.299 --> 00:10:25.820 to this and thinking that short selling a company's 00:10:25.820 --> 00:10:28.980 debt for almost free sounds like a terrible idea, 00:10:29.460 --> 00:10:31.759 critics absolutely agree with you. They argue 00:10:31.759 --> 00:10:34.460 this artificially magnifies the risk of default 00:10:34.460 --> 00:10:37.720 and turns the market into a literal casino. It 00:10:37.720 --> 00:10:40.860 is a highly debated topic. And looking at the 00:10:40.860 --> 00:10:43.019 proponents side from the source material, they 00:10:43.019 --> 00:10:45.860 argue that without this speculation, the entire 00:10:45.860 --> 00:10:49.299 system just freezes up. Really? How so? It comes 00:10:49.299 --> 00:10:52.889 down to liquidity. Imagine a regional bank desperately 00:10:52.889 --> 00:10:55.529 needs to hedge a real loan they've made to protect 00:10:55.529 --> 00:10:58.470 the money of everyday depositors. To buy that 00:10:58.470 --> 00:11:00.610 CDS protection, they need someone willing to 00:11:00.610 --> 00:11:03.230 sell it. Right. If only other banks with exact 00:11:03.230 --> 00:11:05.730 offsetting risks were allowed to trade, finding 00:11:05.730 --> 00:11:07.970 a perfect match would take months and it would 00:11:07.970 --> 00:11:10.590 be incredibly expensive. So the speculators are 00:11:10.590 --> 00:11:12.230 basically just stepping in to take the other 00:11:12.230 --> 00:11:14.529 side of the pet. Yes. They provide the liquidity 00:11:14.529 --> 00:11:16.809 that allows the actual hedgers to protect themselves 00:11:16.809 --> 00:11:19.470 quickly and cheaply. Furthermore, proponents 00:11:19.470 --> 00:11:22.330 argue that a robust market of speculators actually 00:11:22.330 --> 00:11:24.570 creates a barometer for corporate health. Like 00:11:24.570 --> 00:11:28.190 an early warning system. Exactly. If a company 00:11:28.190 --> 00:11:30.870 is secretly failing, speculators will spot the 00:11:30.870 --> 00:11:34.830 weakness and start buying up CDS contracts. This 00:11:34.830 --> 00:11:37.830 drives the price of the CDS up, serving as an 00:11:37.830 --> 00:11:39.990 early warning to regulators and the rest of the 00:11:39.990 --> 00:11:42.590 market that trouble is coming. Well, an early 00:11:42.590 --> 00:11:44.730 warning system sounds great, but if you strip 00:11:44.730 --> 00:11:46.690 away the regulations and make it effectively 00:11:46.690 --> 00:11:49.370 free to place these speculative bets, you don't 00:11:49.370 --> 00:11:51.590 just get a few early warnings. You get a powder 00:11:51.590 --> 00:11:54.110 keg. You really do. And the match that lit that 00:11:54.110 --> 00:11:56.990 tag was Lehman Brothers. Let's look at the ultimate 00:11:56.990 --> 00:12:00.529 stress test in September 2008. Lehman Brothers, 00:12:00.870 --> 00:12:04.090 an absolute titan of Wall Street. files for bankruptcy. 00:12:04.529 --> 00:12:06.389 An unbelievable moment in financial history. 00:12:06.590 --> 00:12:09.529 At the time they filed, Lehman had about $155 00:12:09.529 --> 00:12:12.909 billion in actual outstanding debt. But because 00:12:12.909 --> 00:12:14.909 of all this unchecked speculation we just talked 00:12:14.909 --> 00:12:18.450 about, there was a staggering $400 billion in 00:12:18.450 --> 00:12:21.509 CDS contracts written on Lehman's debt. And this 00:12:21.509 --> 00:12:23.509 is where I totally geek out, because this is 00:12:23.509 --> 00:12:25.309 where the physical mechanics of the market just 00:12:25.309 --> 00:12:27.889 hit a brick wall. Yes, claim this. Traditionally, 00:12:28.250 --> 00:12:30.029 a CDS could be settled through what's called 00:12:30.029 --> 00:12:33.360 physical settlement. The company defaults. The 00:12:33.360 --> 00:12:35.460 bank pays you the full cash value of the bond. 00:12:35.779 --> 00:12:39.120 And you, the buyer, hand over the physical defaulted 00:12:39.120 --> 00:12:42.139 bond to the bank to prove it. A clean swap. But 00:12:42.139 --> 00:12:44.980 look at the math. There were $400 billion worth 00:12:44.980 --> 00:12:48.600 of insurance contracts, but only $155 billion 00:12:48.600 --> 00:12:52.059 of actual Lehman bonds in existence. It was a 00:12:52.059 --> 00:12:54.620 mechanical impossibility to physically settle 00:12:54.620 --> 00:12:57.000 those contracts. You literally cannot physically 00:12:57.000 --> 00:13:00.279 hand over $245 billion in bonds that do not exist. 00:13:00.360 --> 00:13:02.539 So what did they do? They had to rely on a mechanism 00:13:02.539 --> 00:13:05.539 called cash settlement facilitated by a credit 00:13:05.539 --> 00:13:08.600 event auction. The International Swaps and Derivatives 00:13:08.600 --> 00:13:11.820 Association, ISDA, had to step in. They essentially 00:13:11.820 --> 00:13:14.159 locked all the major dealers in a virtual room 00:13:14.159 --> 00:13:17.000 to run a complex Dutch auction. Let's translate 00:13:17.000 --> 00:13:19.200 that jargon for a second. What does a Dutch auction 00:13:19.200 --> 00:13:21.679 actually do in this kind of scenario? It is a 00:13:21.679 --> 00:13:23.759 process designed to find the true market clearing 00:13:23.759 --> 00:13:26.190 price. Instead of starting low and bidding up, 00:13:26.470 --> 00:13:28.330 the auction gathers all the buy and sell orders 00:13:28.330 --> 00:13:30.830 from dealers to figure out the exact price where 00:13:30.830 --> 00:13:33.389 the volume of buyers matches the volume of sellers. 00:13:33.629 --> 00:13:36.009 Okay. Through this process, they determined that 00:13:36.009 --> 00:13:38.850 a defaulted Lehman bond was actually worth just 00:13:38.850 --> 00:13:42.850 8 .625 cents on the dollar. Wow. So if you had 00:13:42.850 --> 00:13:45.590 sold a CDS on Lehman, You didn't have to take 00:13:45.590 --> 00:13:47.929 a physical bond. You simply had to pay the buyer 00:13:47.929 --> 00:13:50.649 the cash difference between the bond's full face 00:13:50.649 --> 00:13:54.549 value and that 8 .625 cents. So over 91 cents 00:13:54.549 --> 00:13:57.169 on the dollar lost. And this triggers what we 00:13:57.169 --> 00:13:59.470 call systemic risk and the domino effect. The 00:13:59.470 --> 00:14:01.830 worst case scenario. Right. Because this wasn't 00:14:01.830 --> 00:14:04.710 just one person making a bet with one bank. The 00:14:04.710 --> 00:14:07.779 market utilized a practice called netting. Company 00:14:07.779 --> 00:14:11.539 A sells a CDS to Company B. Company B turns around 00:14:11.539 --> 00:14:13.679 and sells a slightly different CDS to Company 00:14:13.679 --> 00:14:16.360 C just to pocket a tiny difference in the premium. 00:14:16.539 --> 00:14:19.019 They're all chained together. Exactly. So when 00:14:19.019 --> 00:14:22.000 Lehman falls and these massive 91 cent on the 00:14:22.000 --> 00:14:24.679 dollar payouts are triggered, if Company A doesn't 00:14:24.679 --> 00:14:27.039 have the cash to pay Company B, then Company 00:14:27.039 --> 00:14:30.299 B goes bankrupt and can't pay Company C. The 00:14:30.299 --> 00:14:32.399 dominoes just start falling. And because this 00:14:32.399 --> 00:14:35.360 entire market was private and unregulated, Company 00:14:35.360 --> 00:14:37.919 C had absolutely no idea their survival depended 00:14:37.919 --> 00:14:40.120 on company A, a firm they had never even done 00:14:40.120 --> 00:14:43.200 business with. Which brings us to AIG, American 00:14:43.200 --> 00:14:46.360 International Group. Yes, AIG. They were a massive 00:14:46.360 --> 00:14:48.659 insurance giant, but their financial products 00:14:48.659 --> 00:14:51.539 division had been excessively selling CDS protection. 00:14:52.519 --> 00:14:54.539 They were acting as the seller for billions of 00:14:54.539 --> 00:14:56.580 dollars in these contracts, but they weren't 00:14:56.580 --> 00:14:58.899 hedging their own risk. And circling back to 00:14:58.899 --> 00:15:01.840 our very first point, Because it wasn't legally 00:15:01.840 --> 00:15:04.639 insurance, AIG didn't have to keep the cash on 00:15:04.639 --> 00:15:07.580 hand. Exactly. When a housing bubble burst and 00:15:07.580 --> 00:15:10.039 the underlying assets started declining in value, 00:15:10.519 --> 00:15:13.179 AIG faced potential derivative losses of over 00:15:13.179 --> 00:15:16.139 $100 billion. They simply didn't have the money. 00:15:16.279 --> 00:15:19.419 The well was dry. Completely dry. The U .S. government 00:15:19.419 --> 00:15:22.960 had to step in with an $85 billion federal bailout, 00:15:23.059 --> 00:15:25.139 which by the way eventually grew much larger, 00:15:25.480 --> 00:15:27.740 just to stop the dominoes from crushing the entire 00:15:27.740 --> 00:15:30.309 global economy. So what does this all mean? The 00:15:30.309 --> 00:15:32.710 nominous fell, the global economy crashed, bailouts 00:15:32.710 --> 00:15:35.210 were issued. How did the financial world clean 00:15:35.210 --> 00:15:37.830 up the mess and did they actually fix the underlying 00:15:37.830 --> 00:15:40.070 mechanism? Well, the biggest structural change 00:15:40.070 --> 00:15:43.250 happened in 2009 with a massive shift towards 00:15:43.250 --> 00:15:45.909 centralized clearinghouses, entities like the 00:15:45.909 --> 00:15:48.250 Intercontinental Exchange IC and the CME Group. 00:15:48.429 --> 00:15:50.210 OK, so moving away from the private backroom 00:15:50.210 --> 00:15:52.870 deals. Right. Previously, all these trades were 00:15:52.870 --> 00:15:54.950 over the counter, done in the dark between two 00:15:54.950 --> 00:15:57.429 private parties. A clearing house changes the 00:15:57.429 --> 00:16:00.029 architecture entirely. Imagine a massive, high 00:16:00.029 --> 00:16:02.809 -stakes poker game. Previously, players were 00:16:02.809 --> 00:16:05.570 just passing paper IOUs directly to each other 00:16:05.570 --> 00:16:07.649 across the table. Right, which is fine until 00:16:07.649 --> 00:16:10.289 someone loses. Exactly. Because if one player 00:16:10.289 --> 00:16:13.330 goes completely broke, their IOUs are worthless, 00:16:13.549 --> 00:16:15.649 and it ruins the payouts for the whole game. 00:16:16.330 --> 00:16:18.769 A clearing house means everyone essentially trades 00:16:18.769 --> 00:16:21.230 their cash for chips with the house. The house 00:16:21.230 --> 00:16:23.809 steps into the middle of every single trade. 00:16:24.190 --> 00:16:27.049 It acts as the buyer to every seller and the 00:16:27.049 --> 00:16:29.389 seller to every buyer. So if one trader goes 00:16:29.389 --> 00:16:31.669 bust, the clearinghouse still has the collateral 00:16:31.669 --> 00:16:34.529 to pay the winners. It neutralizes the domino 00:16:34.529 --> 00:16:37.570 effect. And crucially, clearinghouses require 00:16:37.570 --> 00:16:39.909 daily marking to market. Meaning you have to 00:16:39.909 --> 00:16:41.769 prove every single day that you actually have 00:16:41.769 --> 00:16:44.330 the cash or collateral to cover your bets rather 00:16:44.330 --> 00:16:46.009 than just promising you're good for it at the 00:16:46.009 --> 00:16:49.009 end of the year. Exactly. It forces transparency 00:16:49.009 --> 00:16:52.470 onto a market that previously had none. Regulators 00:16:52.470 --> 00:16:55.389 finally had one central location to view traders' 00:16:55.509 --> 00:16:58.389 positions and see the systemic exposure. But 00:16:58.389 --> 00:17:01.230 the core product, the ability to buy that fire 00:17:01.230 --> 00:17:03.389 insurance on your neighbor's house, that still 00:17:03.389 --> 00:17:06.490 exists. It does. And there is a lingering political 00:17:06.490 --> 00:17:09.849 debate about naked CDS. Based on our sources 00:17:09.849 --> 00:17:12.690 and partially presenting both sides here, billionaire 00:17:12.690 --> 00:17:15.049 financier George Soros called for an outright 00:17:15.049 --> 00:17:18.069 ban on naked credit default swaps, calling them 00:17:18.069 --> 00:17:20.630 toxic. He was very vocal about that. He argued 00:17:20.630 --> 00:17:23.329 they allow speculators to launch bear raids where 00:17:23.329 --> 00:17:25.509 traders artificially drive down the credit rating 00:17:25.509 --> 00:17:28.109 of companies or entire countries just to make 00:17:28.109 --> 00:17:30.910 their CDS bets pay off. And his arguments found 00:17:30.910 --> 00:17:34.450 real traction in Europe. In late 2011, the European 00:17:34.450 --> 00:17:37.650 Parliament actually banned naked CDS on the sovereign 00:17:37.650 --> 00:17:40.150 debt of European nations. But on the other side 00:17:40.150 --> 00:17:43.369 of that debate, the source highlights U .S. regulatory 00:17:43.369 --> 00:17:46.069 figures like former Treasury Secretary Timothy 00:17:46.069 --> 00:17:48.630 Gatner and Commodity Futures Trading Commission 00:17:48.630 --> 00:17:51.089 Chairman Gary Gensler. And what was their take? 00:17:51.690 --> 00:17:54.750 They argued against an outright ban. They maintained 00:17:54.750 --> 00:17:57.650 that naked CDS, while obviously risky, provide 00:17:57.650 --> 00:17:59.910 essential liquidity and price discovery for the 00:17:59.910 --> 00:18:02.930 market. Their position was that a ban would stifle 00:18:02.930 --> 00:18:05.079 the market's ability to function. So they thought 00:18:05.079 --> 00:18:07.359 transparency was the answer, not a ban. Right. 00:18:07.400 --> 00:18:09.720 They felt the true solution was simply forcing 00:18:09.720 --> 00:18:12.660 everything through those clearinghouses to ensure 00:18:12.660 --> 00:18:15.440 proper capitalization. But we have to ask, even 00:18:15.440 --> 00:18:18.119 with clearinghouses, is the market actually safe? 00:18:18.759 --> 00:18:21.359 Warren Buffett famously called speculative derivatives 00:18:21.359 --> 00:18:24.019 financial weapons of mass destruction. A very 00:18:24.019 --> 00:18:26.359 famous quote. He pointed out that these contracts 00:18:26.359 --> 00:18:28.839 allow traders to record huge phantom profits 00:18:28.839 --> 00:18:30.819 on their current earnings statements before a 00:18:30.819 --> 00:18:33.019 single penny of a payout ever actually changes 00:18:33.019 --> 00:18:36.150 hands. The psychological incentive to take wild 00:18:36.150 --> 00:18:39.089 risks is just immense. And the source gives us 00:18:39.089 --> 00:18:41.349 a perfect example of how this risk survived the 00:18:41.349 --> 00:18:45.130 2008 reforms. The 2012 JPMorgan London Whale 00:18:45.130 --> 00:18:47.609 incident. Yeah, let's talk about the London Whale. 00:18:47.869 --> 00:18:50.789 This involved a trader named Bruno Ixl. working 00:18:50.789 --> 00:18:53.829 at JP Morgan's chief investment office. So just 00:18:53.829 --> 00:18:57.250 a few years after the 2008 crash, this single 00:18:57.250 --> 00:19:00.990 trader took massive outsized positions in credit 00:19:00.990 --> 00:19:04.250 default swap indices. Essentially, he was making 00:19:04.250 --> 00:19:07.970 gargantuan bets on baskets of corporate default 00:19:07.970 --> 00:19:11.069 risk. And his positions grew so massive that 00:19:11.069 --> 00:19:13.230 he actually began distorting the pricing of the 00:19:13.230 --> 00:19:15.809 market itself. He became a whale in a small pond. 00:19:16.309 --> 00:19:18.970 Exactly. Because his positions were so visibly 00:19:18.970 --> 00:19:21.680 large and complex, he couldn't quietly unwind 00:19:21.680 --> 00:19:24.259 them. Other hedge funds realized he was trapped 00:19:24.259 --> 00:19:27.000 in his own distorted pricing and started aggressively 00:19:27.000 --> 00:19:29.150 betting against him. The market smelled blood 00:19:29.150 --> 00:19:31.309 in the water. They sure did. It ended up costing 00:19:31.309 --> 00:19:34.509 JP Morgan two billion dollars in trading losses. 00:19:34.970 --> 00:19:37.269 Two billion dollars lost by the very institution 00:19:37.269 --> 00:19:40.849 that invented the modern CDS back in 1994, playing 00:19:40.849 --> 00:19:43.250 in a market that was supposed to have been reformed 00:19:43.250 --> 00:19:45.950 and tamed. It just highlights the enduring complexity 00:19:45.950 --> 00:19:47.930 of these instruments. They're often described 00:19:47.930 --> 00:19:50.470 now as a derivative of a derivative. Right. While 00:19:50.470 --> 00:19:53.150 the centralized clearinghouses absolutely reduced 00:19:53.150 --> 00:19:55.630 the systemic domino effect risk that took down 00:19:55.630 --> 00:19:59.329 AIG, the fundamental risk of an individual institution 00:19:59.329 --> 00:20:02.569 making a massive wrong way bet on synthetic instruments 00:20:02.569 --> 00:20:05.089 remains a permanent fixture of the landscape. 00:20:05.390 --> 00:20:07.940 Let's bring this all together. We started with 00:20:07.940 --> 00:20:10.700 the mission to understand this Wall Street boogeyman. 00:20:11.039 --> 00:20:13.200 We've tracked how the credit default swap evolved 00:20:13.200 --> 00:20:15.880 from a niche, genuinely innovative tool designed 00:20:15.880 --> 00:20:18.180 to help banks safely distribute the risk of a 00:20:18.180 --> 00:20:21.180 single Exxon loan. A really specific, practical 00:20:21.180 --> 00:20:23.740 use. But then, stripped of regulatory guardrails 00:20:23.740 --> 00:20:27.839 in 2000, it mutated into a $62 trillion speculative 00:20:27.839 --> 00:20:30.599 market. A market where the majority of participants 00:20:30.599 --> 00:20:33.920 were trading naked swaps, literally placing bets 00:20:33.920 --> 00:20:36.750 on the failure of debt they had absolutely no 00:20:36.750 --> 00:20:39.609 stake in. It fundamentally redefined modern banking. 00:20:40.230 --> 00:20:42.410 It shifted the focus away from traditional lending 00:20:42.410 --> 00:20:44.950 and toward synthetic speculation. Which is pretty 00:20:44.950 --> 00:20:46.730 terrifying when you step back and look at it. 00:20:46.930 --> 00:20:49.990 It is a profound example of financial engineering 00:20:49.990 --> 00:20:53.910 outpacing human comprehension. The mathematical 00:20:53.910 --> 00:20:57.480 tool itself isn't inherently malicious. But when 00:20:57.480 --> 00:20:59.839 that math is applied at a scale of trillions 00:20:59.839 --> 00:21:02.519 of dollars, completely disconnected from the 00:21:02.519 --> 00:21:05.259 underlying physical assets, the consequences 00:21:05.259 --> 00:21:07.920 can literally reshape the world. And that leaves 00:21:07.920 --> 00:21:10.400 us with a final thought to mull over. Something 00:21:10.400 --> 00:21:13.299 to take with you when this deep dive ends. The 00:21:13.299 --> 00:21:16.079 CDS proved that you can completely separate the 00:21:16.079 --> 00:21:18.960 financial risk of failure from the actual ownership 00:21:18.960 --> 00:21:21.859 of an asset. It really did. If traders can make 00:21:21.859 --> 00:21:25.059 vast fortunes purely off the insurance of a failure 00:21:25.059 --> 00:21:27.920 without ever owning the underlying property or 00:21:27.920 --> 00:21:30.359 contributing to the company's growth, We have 00:21:30.359 --> 00:21:32.200 to ask a hard question about the incentives of 00:21:32.200 --> 00:21:35.059 our economic system. Does modern finance actually 00:21:35.059 --> 00:21:37.359 care if a company or even a country succeeds 00:21:37.359 --> 00:21:40.059 or fails? Or does it only care that the volatility 00:21:40.059 --> 00:21:42.480 keeps paying out? Next time you look at your 00:21:42.480 --> 00:21:45.660 neighbor's house, remember somebody somewhere 00:21:45.660 --> 00:21:48.700 might be hoping for a fire. This raises an important 00:21:48.700 --> 00:21:50.839 question about what we truly value in our markets. 00:21:51.059 --> 00:21:52.759 Thanks for listening. We'll see you next time 00:21:52.759 --> 00:21:53.660 on The Deep Dive.