Quiz on the Global Credit Crisis

7 10 2008







 What does Warren Buffett refer to as “Weapons of Mass Destruction” ?






Credit Default Swaps (CDS ). A specific kind of counterparty agreement/ derivative which allows the transfer of third party credit risk  from one party  to the other. One party in the swap  is a lender  and faces  credit  risk  from a third party, and the counterparty in the credit default  swap agrees to insure this risk in exchange  of regular periodic payments  (essentially an insurance premium ). If the third party defaults , the party providing insurance  will have to purchase  from the insured  party the defaulted asset . In turn, the insurer pays the insured the remaining interest on the debt , as well as the principal.


Buffet’s prophecy has come true with AIG the insurance company getting virtually destroyed because of CDS. Buffett’s own insurance companies avoided CDS.







What are “Toxic Debts” and why they are called so?







Toxic debts are poor grade Mortgage Backed Securities or Collateralized Debt Obligations (CDOs) in the books of banks. These are poor because the underlying mortgages have become bad because of defaults by the sub-prime borrowers. These are toxic because their values have to be written down and thereby banks have to incur huge losses.






Why is the US $ 700 Billion bailout being referred as “Privatization of profits and nationalization of losses.”?






 The financial services companies, investment banks and commercial banks have all made huge profits in the last few years and distributed the same to their shareholders and executives. Now, when they are facing bankruptcy the government is bailing them out by giving them tax-payers’ money.



Q. 4:



The US economy is now said to be in the process of “Deleveraging “. What does “Deleveraging” mean?







 A process undertaken by a company in an attempt to reduce its financial leverage. Financial leverage can be beneficial for a company, but if it becomes too risky or harmful, the company may need  to deleverage itself by decreasing the amount  of debt  that it has (by paying it off).Deleveraging is  also called degearing.



By the way, General Electric has announced its plan to deleverage by issuing US  $ 15 billion worth of equity, out of which 3 Billion worth of equity will be subscribed by Warren Buffett.






Several critics of the bailout plan are concerned about “Moral hazards” in such a package. What are the moral hazards in bailout?






The risk that the presence of a contract will affect on the behavior of one or more parties. The classic example is in the insurance industry, where coverage against a loss might increase the risk-taking behavior of the insured.


If the banks and finance companies, know that there is the government waiting to protect them with a bailout package, in case things go wrong, they may be tempted to take more risk.



– G. Mohan




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