What will happen to the credit default swaps?

HoughtonAndAtkeson answered one year ago …

Admittedly, it's a sticky situation.

There's simply too much leverage. In addition to the total corporate debt in America of $3.7 trillion, credit default swap (CDS) "insurance" contracts on that debt are $53 trillion.

And shere's no visibility regarding who owes what because of the off-balance sheet nature of CDS contracts. Think Enron.

In turn, there's no confidence in banks, insurance companies and other financial market participants because no one knows who will be next to blow-up overnight based on huge amounts of CDS contracts that might come due.

With too much leverage, no visibility and no confidence, there is no commercial paper market because market participants have to hoard cash in case of unexpected CDS calls -- because if they lend cash, even on an overnight basis, it may not be returned.

It's hard to say what will happen, but if we had any say, we would immediately terminate the CDS market and call all existing contracts null and void under the authority of national security/emergency powers.

Then we would immediately start a regulated debt insurance market for those lenders or owners of debt who wish to buy debt default protection.

This would help the U.S. economy and "Main Street" because, with the time-bomb of CDS liability removed, counter-party risk between lending parties would be greatly reduced. The commercial-paper markets would almost instantly un-freeze, and regular operating companies could once again access cash to continue normal business activities.

But, while that's what WE would do, the bottom line is that most of the current CDS obligations will never be paid because the amount owed is many times beyond the capacity of the underwriters to pay.

Writing the CDS market off now is calling a spade a spade and removing the pressures that are driving our institutions out of business and raising economic uncertainty to historic levels.