Don’t Stinge on Tyres

By TAN Kee Wee
(MediaCorp 938LIVE’s Money Talks, Thursday, 25 September 2008, 7.50 am and 7.20 pm)

The Formula One racing cars and the cars we drive might look the same. But they are not the same. Probably, the only parts that look similar are the car tyres.

While we motorists don’t need the most high-tech tyres, it’s important that they are in good condition. In reality, most of us are stingy and tend to keep our car tyres longer than we ought to.

Usually, such stinginess would land us with a flat tire in the car park. In the worst case scenario, a tyre could burst while we’re speeding, resulting in many people getting seriously hurt, if not killed.

Imagine the troubles created. The injured has to be rushed to the hospital, the car towed to the garage, and the numerous forms to fill in. All these could be avoided if we had replaced the car tyres early.

In a sense, this is precisely what’s happening to the global financial system. It began more than a year ago with US sub-prime loans estimated, in early 2007, at around US$600 billion. At that time, no one thought it necessary to buy up the sub-prime loans and contain the problem.

Just as it’s too late now to buy new car tyres after the accident has occurred, the amount of money needed to repair the damages due to the sub-prime loans is going to be more than US$600 billion.

Right now, US policy makers are coming up with a bailout plan. US$700 billion is the figure offered because any sum above that requires additional legislation.

Many believe that this bailout plan is not going to work. One of the many reasons is because the sub-prime problem has spread everywhere. Over the years, the sub-prime loans have been used as a base to create thousands of billions of dollars of investment products.

One of these investment products is the credit default swap or CDS. The market size is around US$60,000 billion. A CDS operates very much like an insurance on a bond, or any security, against default.

It’s like the typical fire insurance on your house. In return for a regular premium, if your $1 million house is destroyed by fire, the insurance company will pay you the loss, which is $1 million.

The beauty, or weakness, of a credit default swap is that it operates in an unregulated market. Here, anyone, other than yourself, can speculate by buying any number of insurance contracts for your house against fire.

So if 100 people took up 100 insurance contracts for your house, and a fire destroys your house, the total payout would theoretically be $100 million.

The danger of such an unregulated market is that those offering these insurance contracts tend to be small investment firms. A single loss would wipe them out. Yet they offered such insurances because they believed your house would never catch fire, just as they thought that US house prices would never come down.

So when your house goes up in flames, many insuring parties would go bankrupt. The situation gets complicated because many of the 100 people who are supposed to collect their insurance payouts have obligations to other parties. Now, they themselves cannot pay up.

A chain reaction has been started. That sums up what’s happening in the financial markets today. And since it is an unregulated market, besides the two parties involved in one contract, no one else knows exactly how many contracts there are out there, and on which assets.

These are the challenges facing US policy makers and their US$700 billion bailout plan. It is certainly not enough to sort out the credit default swap market, which is only a small part of the total derivatives market worth about US$500,000 billion.

Perhaps a more workable bailout plan would be to involve other governments. But so far, other governments have not indicated any interest to help out.

Like the stingy car owner, these governments probably think that it’s not necessary to replace the car tyres yet. Or, they could have studied the situation and decided that there is no point in replacing the tyres. The accident will still happen if the car driver is reckless and a perpetual drunk.