Denial of Service

One of the favorite hacker-attacks on web sites involves creating millions of requests, overwhelming the target site’s servers.

The same thing applies in the credit world.

When a bank or a dealer is asked to write a credit default swap by one of the bears, that bank has to decide what rate they will charge to take on that credit risk.  Economically, it’s the same as lending the target company money.

What happened in the Wild West of CDS in 2008 was that the bears requested and got CDS amounting to four times the size of the economy.

And that bearish credit bet wasn’t spread evenly over every company out there.  In fact, it was concentrated in the financials.

So what happened to the financials?

Imagine what would happen if every credit card you had was denied when you had no cash, and had just had a nice dinner.  When you got on the phone to your credit card companies, they all told you that you were “over your limit.”

In this case, the companies, mostly private mortgage lenders, weren’t over their limit because they had borrowed too much.  The banks and dealers were over their limit for exposure to those borrowers, having written CDS many times as large as the debt the borrowers themselves had taken on.

In 2006 and 2007, the targets were the small independent mortgage lenders, followed by the larger non-bank mortgage lenders.  Then came the banks that put too many eggs in the mortgage basket.  By 2008, of course, the targets were Bear and Lehman.  And Goldman and Merrill and Morgan Stanley.  And Fannie and Freddie.

The miracle of mark-to-market meant any bearish bet on any financial could be parlayed into a sure win, if the bets were large enough.

CDS were a black hole for credit that a determined group of bears could use to wipe out any financial company.  Only if you noticed that the light was bending around them could you tell they were there, and by the time you saw the light bending, chances are it was too late.



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