The day after Obama's speech, Wall Street suddenly decided that BP wasn't such a good bet anymore — a fact reflected by the dramatic repricing of credit-default swaps involving the company's debt. A CDS is just two financial actors wagering on whether or not a company is going to default on its loans. When the CDS price or "spread" is low, all that means is that the bookies selling the swap — usually America's biggest banks — aren't charging you much to bet that the company will fail. A low CDS spread is like the long odds you'd get if you walked into a Vegas casino and wanted to bet on the world ending by nightfall: A confident bookie would look out the window, see no missiles falling, and be happy to take 10 bucks from you in exchange for a promise to pay out a million if Armageddon took place before dusk.
Before the disaster in the Gulf, BP had similarly low odds. On the day the spill started in April, the cost of a five-year CDS on the company was 43 — meaning it cost just $43,000 to place a bet that BP would default on $10 million of its debt within five years. "For comparison's sake, the price of U.S. Treasuries during the same time period was in the 35 to 40 ballpark," says Otis Casey, an analyst who tracks CDS prices. Before the spill, in other words, the market considered BP to be almost as safe a bet as the U.S. government. Given the bargain-basement price, investors happily piled up swaps on the firm's debt, often as a way to hedge other bets they'd made in the energy sector. If their investments in Gulf oil extraction went south, say, the default of BP would serve as a form of insurance, helping to cover their losses.
But the spill changed all that. By the first day of June, swaps on BP had risen to 168; by June 15th, just before Obama gave his speech, they had soared to 494. The next day, after BP agreed to set aside $20 billion to cover its liabilities in the Gulf, the number shot up to 614 — meaning it now cost a staggering $614,000 to place a bet on $10 million of BP's debt.
The numbers were eerily similar to AIG's swap numbers shortly before it imploded in September 2008. In three days before the fateful bailout of the firm, the cost of the same five-year CDS deals on the insurance giant soared from 499 to 646 to 824. Like BP, AIG had once been considered among the safest bets in the world, with its swaps regularly trading below 30 before the financial crisis. But as the BP spill worsened through the summer, the market clearly panicked at the prospect of another AIG-like collapse.
"You can't tell me that every derivative dealer didn't crap his pants at first," says Eric Salzman, a former director at Credit Suisse. "They all had meetings to figure out 'What's our exposure to these guys, and what's the exposure all our counterparties and competitors have?' "
It got worse. On June 20th, a few days after Obama's speech, the ratings agency Moody's released an ominous report with the seemingly obscure title "BP Credit Deterioration Hurts CSOs Referencing BP." The report said that large numbers of a type of derivative contract now in circulation around the globe — a beast called a collateralized synthetic obligation, or CSO — were tied, in one way or another, to the fate of BP's debt.
The very existence of these CSOs is a testament to the extravagant insanity of the derivatives market. If a CDS is two bankers sitting on a bench placing bets on whether or not the oil company across the street defaults on its loan, a CSO is a giant basket of those CDS bets whose contents can be chopped up and sold as securities-like products to whatever moron is interested in buying them.
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