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The Real Crime in the Bailout -- Naked CDS Deals

04/26/2009 05:12 am ET | Updated May 25, 2011

The size of our national economy this year is roughly $15 trillion. The size of the Credit Default Swaps (CDS) market is $64 trillion. The whole world GDP is about $56 trillion. How could the CDS market be larger than the world GDP combined? That doesn't make any sense.

The minute I read that many months ago, I realized that there was something unreal going on in the CDS market. By "unreal" I mean something that is given value even though it is not attached to real assets. And the more I researched, the more I realized that was true.

CDS are basically supposed to be insurance on a group of assets. So, if you have a collection of mortgages, loans and other assets, and you would like to insure their value, you get a CDS. This makes sense since some of these underlying assets turned out to be quite risky.

What doesn't make sense is for the insurance market to be many times larger than the value of all of the underlying assets combined. Well, it turns out there is a reason for that. It's called the "naked" CDS. These deals are not attached to any underlying asset. They are not collateralized. They are not attached to anything of real value. They are simply bets. As in wagers. As in gambling.

For example, one bank will bet another bank that a group of mortgages will go under, and the other one will say they won't. Neither one owns the mortgage; they're just "insuring" it in theory. The reality is they are gambling -- pure and simple. Now, the numbers make sense. The CDS market got to be so large because people were making bets in ways that were not attached to the value of the underlying assets at all. So, they were free to bet as much as they liked.

And, of course, the more money they bet, the more money they made. And if they ever lost those bets, they knew didn't have the money to pay it anyway. So, they had all the incentive in the world to keep multiplying their bets.

So far, this is crazy enough, but here comes the really crazy part -- the American taxpayer is now paying off these bets. The people who bet that the housing bubble wouldn't burst or that the assets would retain their value, well, they lost -- but they don't have the money to pay off all of these theoretical bets since they never put any collateral down on them. So, they're turning to the government and saying they're out of money. And we're paying them. That's insane.

It's one thing to pay off mortgages that went bad. It's another to pay off insurance for a collection of bad debts. But it's another thing all together just to pay off gambling debts that otherwise have nothing to do with the economy. We, as the taxpayers, would have to be utter fools to provide the money for these inane bets. And, of course, that's exactly what we're doing now.

AIG was the epicenter for the naked CDS. If you care about this topic at all and want to understand how everything went down, you must read this excellent article by Matt Taibbi in Rolling Stone. As he explains, AIG started this madness and never had the money to back up their bets.

But what really drives me crazy is that I never hear anyone in government talk about this. I've never heard Tim Geithner or Ben Bernanke or any congressman or senator talk about what we should do with the naked CDS. They talk about all of the assets and obligations as if they are all the same. But some of the debts are based on underlying assets and some are not. Is that not an enormous distinction?

The only person who used to be in government who has raised this issue recently is Eliot Spitzer. He said what I have been wondering for a long time now - do we even have to pay these things? Since they are simply gambling wins, if the counterparties who won the bets don't get paid, nothing really happens. They didn't really actually have anything on the line, so it's not like they are going to suffer heavy losses. They are only going to suffer theoretical losses on money that never existed.

Why is Tim Geithner still paying off these debts? If he doesn't understand this phenomenon, he should be fired immediately. If he does understand it, and he thinks it is the obligation of the US taxpayer to pay off the gambling binges of the large financial institutions in the country, then I would seriously question his judgment, to say the least.

The argument they trot out every time is that we must have these financial institutions survive. I don't think that's true, but even if I did believe that, it would be important to shore up the real assets. But under no scenario is it important to pay off debts on imagined assets.

At the very least, can we please have this conversation? I would love for Tim Geithner or anyone else in the administration or Congress to explain why they think these naked CDS must be paid off. Can someone please ask them the question already, before more of our money is funneled over to the "counterparties" who won these bets?