A bubble that no one understands

UK housing bubbles are straightforward affairs. They start with poorly regulated banks, extending too much credit to punters gambling on house price inflation. They end with credit evaporating, falling prices, and the punters losing money. Beyond the housing market, there is always a follow-up recession, lasting perhaps two to three years, with unemployment invariably rising to 3 million.

The UK is now sliding off the top of the fourth bubble in as many decades. We've been here before, and we will come here again. Everyone understand the rules of the game.

The credit default swaps bubble, on the other hand, is a total mystery. It is huge, it has lasted only four years, and no one knows what will happen when it finally bursts.

According to the last Bank of International Settlements survey, in June last year, the outstanding notional value of these derivatives amounted to $45 trillion. The annual GDP of the US economy is just $14 trillion. Here's another number that you can use to frighten little children. Since 2004, this market has grown by 880 percent. Explosive growth doesn't quite capture it.

Credit default swaps are insurance policies on financial products. An investor buys a bond and wants protection in the event that the bond goes bad. In principle, this doesn't seem like such a dangerous idea. After all, we insure our cars and houses, so why not financial products.

Insurance is fine so long as it is not used as a vehicle for speculation. Suppose for a moment, that ten of your neighbours take out fire insurance on your house. One day, you come home and there is a pile of ashes where your home used to be. While this may be a personal tragedy for you, it's payday for the neighbourhood. The insurance company, instead of covering the cost of one house, now pays out ten times that amount.

Credit default swaps allow speculators to take out insurance on assets they don't actually own. Derivatives traders call this creating synthetic credit exposure. When a bond defaults, speculators who suffered no direct loss, are now entitled to payment.

Here we come to the scary bit. Take another look at that number of outstanding credit default swaps. Yes, it really is $45 trillion. Which insurance companies wrote out policies amounting to three times US GDP? Well, AIG is one such company. Could they cover these credit default payouts if there is a rapid increase in bond defaults? Let me be gentle; it is highly doubtful.

The credit default swaps market is unregulated. No one fully understands the risks involved. However, it doesn't take a degree in financial mathematics to understand that massively over insuring a particular risk will lead to a question about the viability of the insurance company writing out those policies.

The process of winding down the CDS market has already started. The notional amounts stabilized in 2008, and hopefully the next BIS report will show this number declining. In the meantime, let us hope that the world can step away from the abyss of a credit default swap induced meltdown.