If the US assumes liability for Credit Default Swaps issued by financial institutions, its potential exposure is many times its gross domestic product.
If the US does not take on this liability it risks annihilation of the modern financial system.
The only solution is to seize both sides.
Ok, Credit Default Swaps, crudely are bond insurance - give someone a loan, and you can get insurance against the borrower defaulting (it gets more complicated, since there can be payments invoked when other triggers short of default activate, but those are refinements).
Very sensible, if you lend someone a lot of money.
There are several problems with them, starting with the fact that they are unregulated; so there is no formal control on assets or reserves (though the bilateral contracts may specify these, more so recently).
Secondly, the odds people got were ridiculous - even a highly rated company has odds of default greater than 10,000:1 on time scales of years . Since the odds were so good, lots of people took the bet.
Since the system is unregulated, some unknown fraction of those issuing CDS do not have the wherewithal to pay them. They will fail to pay if the CDS is triggered. This is "counterparty risk". Some is due to fraud, people who took the fee and gave it to themselves as bonuses, figuring they could walk away and never pay no matter what.
Others just really fucked up the risk analysis and gave out bad unsecured bets.
Thirdly, there was no requirement to actually hold the debt, the CDS could, and can, be taken as a side bet - I get $100 billion if GM defaults on the money Chase lent them!
So the amount of CDS liabilities outstanding are much greater than the underlying base debt.
Much greater.
Now, modern, clever financiers, issue circular CDS's and try to play the changing risk estimates to claw minuscule percentage profits (but a small percentage of a $trillion is a lot of money). So, in theory, the CDS are gross revenue neutral, for each payer there is a payee and things just get shuffled.
But, it is not that simple: some companies (AIG!) were dumb and issued one sided CDS thinking they'd never be called on them - those have several $hundred billion of losses coming. Others think they have re-reinsured their CDS obligations, except some unknown fraction of their counterparties are shell companies, fraudulent micro-institutions and bankrupt hedge funds who can not pay if called on.
The total CDS exposure was estimated at $62 trillion
That is about 4.5 years of US Gross Domestic Product, or rather more than the current World GDP.
Governments have, for the large part, effectively assumed the CDS liabilities.
They could all be triggered in one go if there is a major credit event, like AIG or Citibank formally going bankrupt. (Or some medium sized central European bank with Eastern European exposure...)
The reason governments do this is manyfold:
one is to avoid the cascade of defaults, as it would likely destroy the financial systems - as in personal credit cards would not work, checks would not be honoured, goods would not ship without advance cash payment;
secondly, these financial institutions, like AIG, back major annuities, like those for trust fund recipients (ie most of the major political and financial players and their kids); and pensions, and insurance and legal settlements recipients and charities etc
thirdly, most of the debt issued came from pension funds and such like, including state pension funds, who of course took out CDS on the debt to hedge it. Since the debt is going bad, the pension funds need the CDS payments, and if the issuer goes bankrupt so does the recipient. Which is bad. No CDS, no pension for tens of millions of people in the future, not just current annuity holders.
So, we just have to give all our money to them for a few years.
Nah.
Ok, so mostly these CDS should cancel, at least system wide even if there are individual losers. The link above estimates the cancellation as 98%, IF the counterparty risk is negligible and there are no cascading failures of counterparties.
So we're only talking a $trillion and a bit. Hardly worth worrying about.
Well, except a large part of that net, guaranteed by taxpayers, will go to people who took side bets. Pure profit for them.
NO.
Those are precisely the bastards who ought to lose the CDS coverage, not get an open ended committment to cover their gambling wins.
It is not possible to cover the sidebets of every hedgie and investment banker who decided they had a shot at free money. Those counterparties are failed, the bets are bad, they can walk away.
So, how do we make them?
Ideally, unwind all the CDS outstanding. Cover actual debt holders and concurrently regulate CDS worldwide prohibiting sidebets, or at least making it explicit those are not ever assumable by governments or regulatory authorities.
It is not clear this is possible, at least not on time scales less than decades - there are too many intertwined CDS with staggered multi-year periods and no record of who did what to whom and when.
So, second choice is a punitive tax.
Fine, we cover all the CDSs, if you hold a bond, take the loss, get it back through gov guaranteed CDS, done.
If you don't hold the bond, well, it is profit, no loss, all gain.
But you don't get to issue it to yourself as a bonus; put a, say, 98% windfall tax on third party CDSs - will need some legalese to preclude rapid trade of discounted bad debt to pretend to be a genuine lossy bondholder.
If that doesn't work.
The seize the bastards. All of them.
We pay the CDS, then we seize the recipients.
Because if we hadn't guaranteed them they'd not have got the money, ever, the issuer was bankrupt. So the recipient, if they insist on taking the payout gets seized.
Money comes back. Don't want to be seized, waive the bet.
Then after the dust settles, any surviving viable institutions can be spun off into the private sector again.
Or we can just give all the money to Goldman Sachs me.
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