Speaker 1: Brought to you by the reinvented two thousand twelve Camray.
Speaker 1: It's ready. Are you welcome to Stuff you should know
Speaker 1: from house Stuff Works dot com? Hey, and welcome to
Speaker 1: the podcast. I'm Josh Clark and guess who's with me?
Speaker 1: M Ronald McDonald? Yes, I met Ronald McDonald. That my
Speaker 1: cousin's ride tame birthday already? Really? Yeah, it's pretty cool. No, weird,
Speaker 1: that's the first thing that came into my head. I
Speaker 1: guess it means I'm hungry. I guess, so are you hungry?
Speaker 1: Did you eat today? This is gonna be a fun one.
Speaker 1: Shock you're talking about credit to fault swaps. I know
Speaker 1: we're gonna try to make it sexy. Yes? Should I
Speaker 1: go ahead and get the caveat here? If you want?
Speaker 1: Go ahead? I just want folks to know we usually
Speaker 1: Josh and I do a lot of prep work and
Speaker 1: both have a pretty good understanding. But I'm not ashamed
Speaker 1: to admit that I didn't quite understand this one, and
Speaker 1: so it's pretty thick. Yeah, it might be a little
Speaker 1: different today Josh is going to be teaching me along
Speaker 1: with you. So, okay, are you prepared as prepared as I?
Speaker 1: Can I appreciate you dressing like a little school girl
Speaker 1: today to really kind of complete everything round it out? Um? Okay,
Speaker 1: so well, let me give you an analogy, all right, Okay, So, Chuck,
Speaker 1: Imagine if I went to your health insurance provider, right
Speaker 1: and said, hey, I want to buy Chuck policy okay,
Speaker 1: and they said okay, and they sold it to me,
Speaker 1: and you would be in charge of that policy. I
Speaker 1: would own the policy, so I'd be I'd be accepting
Speaker 1: monthly payments from you. Everything would be fine. I'd be
Speaker 1: probably running around trying to keep you out of accidents
Speaker 1: that kind of thing. But if you did get into
Speaker 1: an accident, I would be on the hook to pay
Speaker 1: your medical expenses, right, you bet you would be. You
Speaker 1: and I are both fully aware that I don't have
Speaker 1: the money to pay your medical expenses. So basically what
Speaker 1: would happen is I'd pay as much as I could
Speaker 1: until I bankrupted myself, and then you'd be on the
Speaker 1: hook to pay your medical expenses. Right, I get that.
Speaker 1: So you'd be in trouble, it bankrupt you and we'd
Speaker 1: both be up the creek, I understand. So are you
Speaker 1: with me? So? Are that makes sense now? Imagine if
Speaker 1: you owned two other people's life or health insurance policies
Speaker 1: just like I owned yours. Okay, sure, Now let's say
Speaker 1: you that accident you got into was a three car
Speaker 1: pile up, just in a mind boggling coincidence with the
Speaker 1: other two people whose health insurance policies you owned with you.
Speaker 1: So now all of a sudden, you guys are all
Speaker 1: in an accident, all need healthcare, and nobody has the
Speaker 1: money to pay out. I can't pay yours, and you
Speaker 1: have your own problems, so you can't pay the other
Speaker 1: two peoples. So imagine if this just keeps going on
Speaker 1: and on and on and on in this infinite car
Speaker 1: pile up, and everybody owns everybody else's insurance policy but
Speaker 1: nobody can pay. Okay, seems it does. It is awful.
Speaker 1: It's kind of nightmares. Right. So the good thing is
Speaker 1: that this can't happen because health insurance is a heavily
Speaker 1: regulated industry. So you've got um you have federal inspectors
Speaker 1: who can go to a health inst and say, let
Speaker 1: me see your books. I want to make sure you
Speaker 1: can cover every policy that you have. Right, did they
Speaker 1: do that? Yeah? And what's more, they can't sell your
Speaker 1: insurance policy to anybody, right, okay. Right, with credit default swaps,
Speaker 1: all the all the good things that keep health insurance
Speaker 1: from going pear shapes are not present, although they are
Speaker 1: pretty much insurance policies on debt. Okay, okay, this is
Speaker 1: where I start to get a little fuzzy. I understand
Speaker 1: it does get a little fuzzy at this point. It's
Speaker 1: a bit of an abstract. Um, it's a bit abstract
Speaker 1: for me. It is, it's insane. You have to be
Speaker 1: a a genuinely savvy person and possibly a bit evil
Speaker 1: to be able to really accurately trade or make money
Speaker 1: in credit default swaps. But you don't have to be
Speaker 1: evil to describe them to people in podcast land. No, No,
Speaker 1: you just have to read them, read the article several times,
Speaker 1: and write it too. It doesn't hurt to write it
Speaker 1: several times, and it was still a little bit maybe
Speaker 1: you have to write it writing it out. Um, okay,
Speaker 1: So let me give you a little bit background credit
Speaker 1: default swaps for these financial instruments that came out of
Speaker 1: the late nineties. Right, it's a derivative. It is a derivative,
Speaker 1: and a derivative is a derivative. I do know this.
Speaker 1: It's a financial instrument, UH that has a value based
Speaker 1: on the value of another financial instrument. Right. So let's
Speaker 1: say you're trading in oil futures, right, UM that actually
Speaker 1: the value of that future is based on the value
Speaker 1: of oil. It has an actual value, right. UM. With this,
Speaker 1: this would be based on UH future and oil future. Right.
Speaker 1: So it doesn't have its own value. Its values based
Speaker 1: on the value of something else. So let's say you
Speaker 1: bought a bunch of oil futures and you were worried
Speaker 1: that the price of oil was going to go down, right,
Speaker 1: and so you'd be getting the oil cheaper oil for
Speaker 1: than what you paid for it. You would you would
Speaker 1: lose money. You could I'm not sure if you could
Speaker 1: or not, But let's say theoretically you could buy a
Speaker 1: credit default swap to cover that eventuality. So it's like insurance.
Speaker 1: That's exactly what it is. So in the nineties, UM,
Speaker 1: they started issuing these things on municipal bonds, which are
Speaker 1: or about as safe as it gets. UM. Almost every
Speaker 1: city except for probably Detroit, has a triple a UM
Speaker 1: credit rating. Right. So a municipal bond is a loan
Speaker 1: made to a city to finance a project. That's why
Speaker 1: it's a little more stable than your average situation. Right,
Speaker 1: And the city can tax its citizens to pay off
Speaker 1: its debts, which is one of the reasons why they're
Speaker 1: so stable and reliable and credit worthy. Right, gotcha. So
Speaker 1: the thing is, like all these banks that are issuing
Speaker 1: these policies are saying, you know what, we're making just
Speaker 1: tons of extra income because they're they're um selling these
Speaker 1: credit default swaps to people who are loaning money to cities.
Speaker 1: The cities are definitely paying it back, so there's no
Speaker 1: there's no um default on the loan, and so the
Speaker 1: banks are just can inect your money. So these things
Speaker 1: started to take off like a rocket. Who's the day,
Speaker 1: That's what I'm confused about. That's the bank they actually
Speaker 1: issue these. Okay, so let's say let's say that, um,
Speaker 1: I have a bunch of money and Atlanta needs to
Speaker 1: repay four hundred so I buy a bunch of city bonds,
Speaker 1: a bunch of municipal bonds, which are basically it's a
Speaker 1: city issuing debt. I give them a bunch of money
Speaker 1: and then give me a bond and return to hang
Speaker 1: on too, and I'll earn like slow, steady, small interest. Right,
Speaker 1: I would buy a credit default swap from a bank,
Speaker 1: right to say, if this city doesn't pay me back,
Speaker 1: then I can cash in this credit default swap, this
Speaker 1: insurance policy against the against the the the loan I
Speaker 1: gave the city, Okay, and then I'll actually make more
Speaker 1: money because like a life insurance policy, it has it's
Speaker 1: worth more than say the actual loan. Okay, se coming
Speaker 1: into focus, Okay, is it? Is it? Okay, we should
Speaker 1: we should talk together before we do these ruin everything. Yeah,
Speaker 1: I guess you're right. Yeah, so um okay, so the
Speaker 1: so the It made a huge source of extra income
Speaker 1: for the banks that were issuing these these insurance policies
Speaker 1: because no municipality was defaulting on their loans, right, Um,
Speaker 1: So they started to look for other places where they
Speaker 1: could sell these things or people they could sell them to,
Speaker 1: of course, and essentially you can cover any debt whatsoever,
Speaker 1: um with a credit default swap. Well, that's amazing to me.
Speaker 1: And I think one of the reasons why it was
Speaker 1: able to take to take off like this is because
Speaker 1: they're unregulated. It seems like, you know, greed as always
Speaker 1: kind of takes hold they're like, hey, if we do
Speaker 1: it for this, we can do it for this is
Speaker 1: how it worked. They're wholly and completely to this day unregulated.
Speaker 1: It's amazing. So, which is why that that scenario that
Speaker 1: I gave you at the beginning about your health insurance policy,
Speaker 1: that's dead on with credit default swaps. So think about this.
Speaker 1: Say a bank issues, um, a credit default obligation to
Speaker 1: somebody who has um created debt. Right Um. That that
Speaker 1: guy who loaned money to the city for that road project. Okay,
Speaker 1: so he buys a credit default sat. Now there's two
Speaker 1: players in this one. Really, as far as the insurance
Speaker 1: policy goes. You've got the bank who has the issuers
Speaker 1: side of it, and then you've got me, uh, the
Speaker 1: guy who made the loan to the city, who has
Speaker 1: the buyer's side of it. And you pay a premium
Speaker 1: like right um, And then both of the sides of
Speaker 1: this policy can be sold to anybody at any time
Speaker 1: who wants to buy them, and neither side needs to
Speaker 1: notify the other person. Really, what's more, because it's unregulated, Um,
Speaker 1: if the bank sells it to you, right, so, now
Speaker 1: you own the issuer portion of my credit default swap.
Speaker 1: So I'm now making payments to you. You don't have
Speaker 1: to prove to them at all whether you have the
Speaker 1: money to cover it. If that, if the city defaults
Speaker 1: on the loan. This sounds two things. This strikes me.
Speaker 1: It sounds like la la land, and it sounds like
Speaker 1: a really bad idea. It is because, Chuck, here's the problem,
Speaker 1: right if you if we haven't come up with enough
Speaker 1: problems yet. Um, since it's also since it's unregulated, the
Speaker 1: way that a credit default swap can be called in
Speaker 1: if I'm the buyer is through a credit event, and
Speaker 1: there's certain credit events, one of the big ones bankruptcy.
Speaker 1: One of them is if the city just says we're
Speaker 1: not repaying your loan, that would be a credit event,
Speaker 1: right right, and then that triggers payment problem is since
Speaker 1: they're unregulated, anybody can dispute whether or not a credit
Speaker 1: event actually took place, whether the event that the buyer
Speaker 1: is saying, give me my money over actually was a
Speaker 1: credit event. So there's mediation, there's lawsuits. Well who did
Speaker 1: they dispute it to? Though, since there's nobody they take
Speaker 1: the other person to course, they just start seeing each other. Yes,
Speaker 1: more litigation, that's exactly what we need. Right. Um. The
Speaker 1: thing is, it's it's still, like I said, to this day, unregulated.
Speaker 1: There's actually an independent body of banks and investment houses
Speaker 1: and other other investors uh and securities analysts I believe,
Speaker 1: who have come together to form an arbitrating panel for
Speaker 1: credit default swaps. That's a good thing, right, it is
Speaker 1: a good thing. But again, it exists outside of the government.
Speaker 1: So everybody who's involved in the credit default market had
Speaker 1: to agree, Yes, we'll listen to these people. Their decision
Speaker 1: is binding. But is that I mean, existing outside the government,
Speaker 1: and it isn't necessarily a bad thing. No, it isn't.
Speaker 1: But I think to me, it's just kind of one
Speaker 1: more point, like where's the SEC. And I actually read
Speaker 1: that the SEC and the Treasury Department we're encouraging this
Speaker 1: panel to form, like please go handle this for us
Speaker 1: because we don't have any teeth whatsoever. Um. So yeah,
Speaker 1: so that's the problem with being unregulated, right, Well, it
Speaker 1: sounds like it's right for a nightmare scenario to like,
Speaker 1: first we're talking about let me let me set the
Speaker 1: stage for you, okay, okay. In July two thousand seven,
Speaker 1: you remember the good, heady days of the bubble before
Speaker 1: at first, okay, the um the subprime mortgage market was
Speaker 1: valued at. Uh, let's see, I think seven trillion dollars
Speaker 1: in the US and them in the US. But the
Speaker 1: US is I think the biggest player in the subprime
Speaker 1: mortgage market, right, And this is when the subprime mortgage
Speaker 1: market was still valuable. So seven trillion. Do you know
Speaker 1: in July two thousand seven, what the credit default swaps
Speaker 1: market was valued at? I do, but I'm gonna let
Speaker 1: you say it. Are you ready? Sixty two trillion dollars?
Speaker 1: That's unbelievable. Do you know what the global g d
Speaker 1: P was for two thousand and eight? I do, but
Speaker 1: I'm gonna let you say it. You're ready? Sixty nine
Speaker 1: trillion dollars? Wow, So it's short of the globe of
Speaker 1: the global GDP. So basically, if every country in the
Speaker 1: entire world could suddenly sell off everything, every good in
Speaker 1: service that produced any year to say some aliens, right,
Speaker 1: we'd still just we'd have like five trillion dollars left
Speaker 1: over for the year. It sounds like this is the
Speaker 1: biggest market of anything in the world. Almost, Yes, yeah,
Speaker 1: it's I think, So I can't I can't think of
Speaker 1: anything that that's valued up more than that and it
Speaker 1: just think about it. This is the the late nineties,
Speaker 1: So in a decade, this unregulated market went from zero
Speaker 1: to sixty two trillion. Well, what's amazing is like your
Speaker 1: references the mortgage crisis, and that's a scenario you can
Speaker 1: you can track it down to a house eventually, like
Speaker 1: a physical property. But this is sort of like exist
Speaker 1: in the ether, So where there's no end of the line,
Speaker 1: it seems like no, there isn't um, which is why
Speaker 1: you can say no credit credit event didn't occure, or no,
Speaker 1: I'm not gonna pay up, or I don't have the
Speaker 1: money to pay up. I'm sorry. I was enjoying the
Speaker 1: monthly payments you're paying me and I really thought you
Speaker 1: were gonna be okay. But now that you've gone under,
Speaker 1: I can't. I can't pay you. You know, I can't
Speaker 1: pay you um the money that I owe you, Right,
Speaker 1: so what does this us? Well, hold on, let me
Speaker 1: say one more thing. The whole reason this this market
Speaker 1: blew up was because it's actually a way to bet
Speaker 1: on the health of a company. Right, So if you
Speaker 1: have a bunch of investors who have buyers shares of
Speaker 1: credit default swaps. Then they're saying, uh, they think that
Speaker 1: that company is gonna go under because they're paying monthly premiums.
Speaker 1: But it's on the premise that you um that that
Speaker 1: company is gonna go under, and there will be a
Speaker 1: much bigger payout, yes, even more. Um, you can actually
Speaker 1: short sell a company, driving its value down if you
Speaker 1: if you own enough shares, or you can borrow enough
Speaker 1: shares and sell them on a margin. Um. If you
Speaker 1: have credit default swaps, it'll actually be a bigger payout
Speaker 1: if you can drive that company into bankruptcy because you've
Speaker 1: just created a credit event that seeing is unbelievable. Okay,
Speaker 1: So this is where the world was teetering right now.
Speaker 1: And in two thousand seven eight um Lehman Brothers actually
Speaker 1: went down not because of subprime mortgage securities, but because
Speaker 1: of all the credit default swaps. This huge domino effect
Speaker 1: was triggered. A bunch of people had credit default swaps
Speaker 1: on the subprime mortgage securities that they owned, right oops. Indeed,
Speaker 1: so when the subprime mortgage securities went south, everybody turned
Speaker 1: to their credit default swaps. I'm like, well, I'm I'm
Speaker 1: glad I have these. Now, wait a minute, who owns
Speaker 1: my policy? Because there's no paper trail whatsoever you have,
Speaker 1: you track down who owns it and then hope that
Speaker 1: they have the money to pay you. All these banks
Speaker 1: were finding out the people that own their their um
Speaker 1: their insurers policy, uh, didn't have the money to pay them.
Speaker 1: The problem is is when you're writing your balance sheet.
Speaker 1: If you have a major loss, but you have a
Speaker 1: credit default swap that covers it and it pays out,
Speaker 1: you're fine and you're staying in the red and you
Speaker 1: probably actually made a little bit of money. If you
Speaker 1: have a major loss and there's no credit default swap
Speaker 1: to cover it can't be covered, then that's when your
Speaker 1: balance she goes into I'm sorry, into the red, right,
Speaker 1: which is the bad one? Right right? Yeah, I get that. Okay,
Speaker 1: so um, that's what happened with Lehman Brothers. That's why
Speaker 1: A I G got all of that bail out money
Speaker 1: because they had a bunch of credit to fault swaps.
Speaker 1: And now there's this panel that I talked about, the
Speaker 1: independent panel that's actually gotten the value of the market
Speaker 1: down to about twenty trillion. I wonder, however, dependent Well, yeah,
Speaker 1: I think it's probably all revolving door and stuff like
Speaker 1: they if they haven't held public office in the last
Speaker 1: couple of years, they will work for Goldman Sax. I
Speaker 1: think Goldmen Sex is a major player in that panel. Yeah,
Speaker 1: well this sounds like I get it now, do you really? Yeah? Yeah? Yeah, alright,
Speaker 1: so thanks for that, but thank you. Where does this lead?
Speaker 1: I mean, is this uh, something's got to happen at
Speaker 1: some point. It seems like or else it's setting us
Speaker 1: up for even more failure economically, right, No, no, no, no,
Speaker 1: most definitely. I think it's just um, it seems like
Speaker 1: the credit of fault swaps market is being tamed. Like
Speaker 1: I said, we've gone from sixty two trillion to twenty
Speaker 1: trillion in just like two years. But I think it's
Speaker 1: symptomatic of the lack of regulation and oversight that that
Speaker 1: we've had. We have the SEC, but they don't have
Speaker 1: any teeth in the teeth that they do have or
Speaker 1: dole and and can basically just gum butter, you know. Um.
Speaker 1: And then the fact that there's a whole over the
Speaker 1: counter markets that are allowed to get this big without
Speaker 1: any regulation whatsoever. I think it seems there seems to
Speaker 1: be a pattern, Chuck, like the Great Depression was the
Speaker 1: result of complete and total lack of oversight and regulation
Speaker 1: mixed with unbridled Greek. Right, So then we come up
Speaker 1: with things like the SEC, the FDA, all these things
Speaker 1: that all these regulatory bodies that came out of the
Speaker 1: Great Depression in the in the crash to prevent it
Speaker 1: from happening again. Then we got lazy, so then this
Speaker 1: happened again. There's going to be more regulation. The problem
Speaker 1: is people always say, you know, pro business people always
Speaker 1: a you know, regulation strangles business. I disagree. I think
Speaker 1: the whole point to um capitalism is to make as
Speaker 1: much money as you can as fast as you can write,
Speaker 1: which means that no matter how many roadblocks the government
Speaker 1: throws up, all it's doing is presenting challenges for very clever,
Speaker 1: greedy people, and they'll always find a loophole always. Yeah.
Speaker 1: So I think that's where it's leading us to more regulation.
Speaker 1: But I don't think there's ever going to be a
Speaker 1: saving grace where nothing like this ever happens again. Well,
Speaker 1: when you're talking now trillion dollars, that's still such a
Speaker 1: massive amount that it's it's kind of frightening to think
Speaker 1: about it is, but it's doable. I think if the US, Japan,
Speaker 1: and the UK got together and sold everything off in
Speaker 1: a fire cell, we could cover it. Yeah all right,
Speaker 1: well I get it. Thanks good, I'm feeling pretty good
Speaker 1: about myself. Were default swaps? Ahoy? Yeah, this this was
Speaker 1: sort of like some math kind of just goes so
Speaker 1: far above my head. I can read it and read
Speaker 1: it and read it and it still just doesn't sink in.
Speaker 1: I'm like that with the algebra. I get geometry, but
Speaker 1: not algebra. We should do a podcast on it and
Speaker 1: fumble our way through that so we could. Yeah, yeah,
Speaker 1: so there you have. It's awesome. All right, Are we
Speaker 1: still plugging things anymore? Sure? Josh. We'll just give a
Speaker 1: quickie plug to the blog. Alright, blog and stuff you
Speaker 1: should know blog that we write um once a day
Speaker 1: each and it's on the right side of the homepage.
Speaker 1: Very nice and it's been enjoyable and that's all we
Speaker 1: need to say. Yes, that is it? So then what
Speaker 1: does that mean? Chuck's listener mail time? It is indeed,
Speaker 1: And Josh, this one I'm really looking forward to reading.
Speaker 1: Which one is it? This is the I ME incident?
Speaker 1: We get a lot of these uh for those of you.
Speaker 1: Obviously you don't know because you don't get a listener mail.
Speaker 1: We have a lot of people that take us to
Speaker 1: task on the use of I and me, Josh and I,
Speaker 1: Josh and me and me and josh I and Josh
Speaker 1: I seem to get it a lot more than you,
Speaker 1: though we both do. We Yeah, So if people take
Speaker 1: us to task and tell us that we're not being
Speaker 1: a responsible uh with our grammar. And I got this
Speaker 1: email from Keith and Alton, Illinois, and Keith says, I
Speaker 1: just want to let you know that as a student
Speaker 1: of linguistics, I'd like to tell you that in a
Speaker 1: compound object e g. Send listener mail to Chuck and
Speaker 1: I slash me, it is totally fine to use whichever
Speaker 1: pronoun you think sounds better. I've read a link the
Speaker 1: explanation that justifies the use of eye in a compound object,
Speaker 1: but I won't bore you with it. My main point
Speaker 1: is this talk in whatever way it sounds right to you,
Speaker 1: while keeping in mind that certain non standard usage of
Speaker 1: words might put off some snooty pedants. Awesome, Keith, and
Speaker 1: he did actually send a link. I'm not gonna bore
Speaker 1: you either. But there was a book by Steven Pinker
Speaker 1: called The Language Instinct, and uh, I mean he sent
Speaker 1: me a whole page where the guy basically breaks it
Speaker 1: down and in the end, I'll just read the one
Speaker 1: sentence Stephen Pinker. Really yeah, Ok, do you know him?
Speaker 1: I just heard of him last night for the first time.
Speaker 1: Really yeah, it's odd. How about that? So? Uh, The
Speaker 1: last sentence of his thing says, by the logic of grammar,
Speaker 1: the pronoun is free to have any case it wants.
Speaker 1: I agree. I think the point of communication is to
Speaker 1: get your get your idea across to somebody exactly. And
Speaker 1: I think interchanging iron me so gets the point across. Yeah.
Speaker 1: I think if you can get your point across with
Speaker 1: grunts and hand gestures or if that's proper communication. Right.
Speaker 1: And when it comes down to it, the name of
Speaker 1: this show is not grammar. You should know, right. And
Speaker 1: we are always the first ones to say we're not
Speaker 1: you know, we're not perfect, so uh layoff. Yeah a
Speaker 1: matter of fact, Keith, go ahead and send us your
Speaker 1: your address because we're gonna send you a T shirt.
Speaker 1: My man, that was cool, Thanks for coming to the rescue. Yeah, Keith,
Speaker 1: shirt size and address, and well, thank you for having
Speaker 1: our backs on this. So if you want to have
Speaker 1: our backs, if you want to take us the task,
Speaker 1: if you're a grammar Nazi or a well whatever, how
Speaker 1: about we re record that part ready. So if you
Speaker 1: want to have our backs or you want to take
Speaker 1: us to task like the grammar Nazis that rode in Um,
Speaker 1: just go ahead and send us an email to stuff
Speaker 1: podcast at how stuff works dot com for more on
Speaker 1: this and thousands of other topics. Does it how stuff
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