Chapter 117: CDS market risk

Credit default insurance is perhaps the biggest problem?

Louis was taken aback when he heard Zhou Ming say this, but then he laughed heartily, 'My dearest Mr. Zhou Ming, you really dare to say it. In the entire subprime loan sector, credit default insurance is obviously the best layer of shackles. I never thought that it would become a problem with you. Your words have opened my eyes. Could it be that you set this order?'

In the face of such mockery, Lin Muqing immediately stood up and said, 'I think Zhou Ming's words are absolutely fine. This insurance sounds very good, but in the final analysis, it is nothing more than a transfer of risk. The transfer may just be from one person to another, but the risk itself will not change. If there is a default, it doesn't matter who pays for it, does it?'

'It seems that you really don't have any concept at all. I need to give you a basic introduction to financial knowledge.'

Louis sighed deliberately and said, 'Although the final subprime loans were ultimately issued to ordinary people, most of these credit default insurance policies were actually issued to intermediary banks or lending institutions. In other words, these institutions that issue subprime loans take out insurance on all the subprime loans they issue.'

'The original intention of taking out this insurance was also very simple, because most of these lending institutions are small companies, so they do not have high assets. They only have a few million or tens of millions of dollars, and very few reach the scale of hundreds of millions. It is for this reason that although they can obtain the most preferential loans from banks through formal channels, they cannot obtain very high-amount loans due to their own lack of collateral assets. However, there are so many people outside who need loans and do not meet the bank's conditions, waiting for loans. This is when credit default insurance came about.'

Louis continued, 'Let me give you an example. I plan to issue 300 million in subprime loans, but I don't have that kind of money. I go to the bank to get a preferential loan, but I don't qualify. So I find an insurance company and ask it to guarantee the default of my loans. I can pay it an annual premium of 5 million, for a total of 50 million over ten years.'

'If my investment doesn't default, then the insurance company gets the premium for nothing, but if I default, on the contrary, the insurance company has to compensate me.'

Louis spread out his hands: 'In fact, I don't lose money on this, because the 300 million I have is for lending money. Let's compare it to mortgage lending. I calculate that my average subprime loan is 8 percentage points, so after ten years I'll make about 140 million. Then I take 50 million out of the middle to pay for the insurance, and I still make a net profit of 90 million. Even if there is a default, it doesn't matter, because the insurance company will help me pay for it, and I'll make a risk-free profit.'

Louis said, 'Of course, the insurance company is not stupid. It will not immediately accept the insurance contract. It will first conduct a risk assessment. Let's say the risk of default is one percent. Then I only need to accept one hundred insurance contracts to get five billion in insurance payments. Even if one of them defaults, I will still make a net profit of 4.7 billion after paying out 300 million. Even if there is an accident and three of them default at the same time, I will still make 4 billion. Why wouldn't I do such a sure-fire business?'

Louis paused deliberately after saying this, and looked around at Zhou Ming and Lin Muqing with his eyes, and asked, 'Do you understand after I explained it like this? This credit default insurance may sound like a kind of risk transfer, but in fact it is a kind of risk sharing, which improves everyone's ability to resist risks.'

Zhou Ming and Lin Muqing did not say anything, and Louis was not surprised by this. He just said, 'I know that there are many loopholes in your place, but we can't do that here, because this is a very mature financial market. No matter what the loopholes are, someone will help to plug them up. So please don't look at us with your outdated ideas in the future, okay?'

Lin Muqing didn't know what to say at this time, and she could only look at Zhou Ming helplessly.

Zhou Ming shook his head and said to Louis, 'There is nothing wrong with your explanation, but I still insist on my own opinion. The financial market is just a place for capital exchange, and it does not generate any added value. In addition, in the capital market, returns and risks coexist. There is no such thing as a surefire business. There is definitely something wrong with such a high market profit without risk, but the problem has not yet been discovered.'

Louis laughed happily: 'Is that so? It seems that Mr. Zhou Ming is really stubborn. Then I think I will be very looking forward to you finding this miracle problem.'

After saying this, Louis left the living room, leaving behind only a string of scornful laughter.

This laughter made Lin Muqing feel very uncomfortable, but she had no idea how to respond. In the end, she could only say to Zhou Ming, 'Why don't we try it another way?'

Faced with Lin Muqing's sudden question, Zhou Ming was a little surprised and asked, 'Muqing, do you not believe in me either?'

Lin Muqing immediately explained, 'Zhou Ming, I didn't mean that. I know you are very confident in your judgment, and I also trust your judgment, because I also feel that subprime loans sound problematic in some way. But now we still haven't found anything, have we?'

Zhou Ming smiled and said to Lin Muqing, "Muqing, I think you've misunderstood. I'm not being brave, I really think there are big problems with subprime loans.'

'Really?" Lin Muqing still didn't seem to believe him.

'Of course it's true. Maybe I might be a bit cocky in front of Louis, but you're not a stranger, Muqing, so why would I be cocky in front of you?' Zhou Ming said.

Zhou Ming was telling the truth. With his afterlife memories, he knew very well that these subprime loans would definitely run into problems. It was just that this time, he wasn't acting as a prophet, but was going to burst the bubble himself. In front of Louis, Zhou Ming didn't really show off his confidence.

However, these are things that Lin Muqing does not know. To her, she felt relieved when she heard Zhou Ming say this, because the Zhou Ming she remembers is not without self-esteem, but his self-esteem is based on confidence and reason. And in front of his own people, the original intention is to discuss countermeasures, so there is no need to forcefully hold that boring frame, and he has never tried to be strong in front of her.

Zhou Ming thought about it for a while before saying, 'Muqing, no matter how low the risk assessment is, it is based on the subprime mortgage market. Now the US economy is growing rapidly, and the risk of such loans is very low. But what if there is a problem with the subprime mortgage market one day? Will all the guarantees disappear then?'

'And there's one more important point!' Zhou Ming said, "People are profit-seeking. I don't believe that such a sure-fire business would not attract people to speculate and create bubbles. As long as bubbles appear, the market itself will be vulnerable.'

'If you say so, Zhou Ming, I suddenly remember one thing, the CDS market," Lin Muqing said suddenly.

'CDS market? Are you referring to the market for credit default insurance?' Zhou Ming asked.

Lin Muqing nodded and said, "That's right. Just now, I checked the information materials of the Bray Insurance Company, which is an insurance company directly controlled by the Adams family. I found some very interesting information. He once spent 4 billion U.S. dollars on 100 CDS contracts.'

This made Zhou Ming's eyes light up. He said happily, "It really is like this. I knew that there would definitely be great hidden dangers in such a big market!'

Lin Muqing was also very happy, but her happiness was more about being able to help Zhou Ming. Of course, as a financial investor, she also understood what 4 billion US dollars for 100 CDS contracts meant, and that was speculation. Because according to Louis's previous calculations, assuming that each CDS contract was worth 50 million US dollars, then 100 contracts would be 5 billion US dollars.

Forty billion versus fifty billion, it seems that Bray is making a profit, but bear in mind that the fifty billion is to be paid over ten years, and not to mention the possibility of accidents in those ten years, the inflation alone is unacceptable.

Then it is not difficult to imagine that there must be an insurance company that has taken a hundred CDS contracts. This insurance company alone is worried that an accident may really occur, after all, this can also be considered a futures contract, so the best way for him to avoid risk is to sell all these contracts directly.

Perhaps the insurance company initially set the price at 2 to 2.5 billion US dollars. Although this is half of the 5 billion, it will only be gradually received over a period of ten years, and the risk will still have to be borne. How is this comparable to receiving 2.5 billion US dollars immediately without any risk?

Then the company that bought these 100 CDS contracts didn't want to wait ten years to get the money either, or it didn't want to bear the risk, so it went on to sell these 100 contracts on, for 2.7 billion or 2.8 billion. Or if no one could come up with that kind of money at once, it could also sell these CDS contracts one by one like stocks, and in the end, under market speculation, they gradually soared to the high price of 4 billion for 100 contracts.

'At the high price of 4 billion US dollars for 100 contracts, I don't think there is much profit left. As long as one contract defaults, I think someone will go bankrupt, because he has already paid 4 billion to buy the contract, can he afford to pay more? Even if the Adams family is behind this company, I'm afraid they can't afford it,' said Zhou Ming.

'Will Boley also list all these contracts for sale again? Maybe that was their original plan,' Lin Muqing speculated.

Zhou Ming shook his head and said, 'In fact, whether or not Bray will eventually sell is not important. What's important is that he has already bought it, which proves that the bubble in the CDS contract or the subprime mortgage market has already been inflated. People are not buying the returns ten years from now, but are looking for a buyer now. This kind of trading, where one person passes the baton to the next, will cause a tsunami of turmoil if it stops.'

'But how can we make him stop?' Lin Muqing asked.

Zhou Ming thought for a moment and then asked, 'Muqing, if you were an investor, under what circumstances would you stop buying these CDS contracts?'

Lin Muqing frowned and tentatively answered, "When the risk is too high or the profit margin is too small?'

'So when would the risk of these CDS contracts become greater or the profit margin become smaller?" Zhou Ming asked again.

'Of course when there is a default...'

Lin Muqing's answer was just a sentence and she didn't continue because she already understood Zhou Ming's thinking: 'Zhou Ming, are you saying that you want to create a default?'

Zhou Ming nodded and then shook his head, saying, 'A default must be created, because the occurrence of a default is the primary condition for bursting the bubble. However, before that, we must first determine whether the current subprime loans have really inflated to a drastic enough degree.'

'But this requires more detailed market data,' said Lin Muqing, a little embarrassed.

Zhou Ming said casually, "Sister Muqing, you are ignoring the existence of Mr. Louis. He is the patriarch of the Lowell family!'

Lin Muqing laughed, "I really forgot about that.'

Meanwhile, in another room, Louis sneezed violently, and his body involuntarily shivered. He had a very bad feeling in his heart.