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Credit Default Swaps for Dummies

The staggering amounts of money at risk in global markets cite the use of credit default swaps (CDSs) and other types of complex derivatives as contributing factors to the latest global market crisis. The puzzle problem is that hardly anyone really understands what CDSs are, nor can they wrap their heads around the extreme credit liabilities destroying financial firms, and depleting country treasury reserves.

Years ago cause I had to, I forced myself to wade through a 150-page analysis of credit derivative structures written by financial engineers and other mathematical geniuses. It was powerful, awful and boring - my thoughts were that, thank goodness - portfolio manager types can keep these close to earn their bread and butter while I figure out another route. Here is a layman's description of how these instruments work.

Sophisticated CFAs avert your eyes here. It is a two-year-old insurance company called BlueLine Inc, well-run, well capitalised for a start-up and generating great premium revenue from life insurance sales.

In less than two years, they have signed up more than 10,000 young insured men (in their early 20s) for $100,000 face value life policies at $200 per premium per man per year. This is going to be a complete cakewalk, the CFO says. "We all know that statistically only 1-5 young people in that group will pass away each year (note this is a made up statistic). We hope everyone remains healthy and happy for years so that we can build up our conservative cash reserve positions."

Regrettably, within the third year, every young man has gone to glory.

Their beneficiaries present the policies for payment:10,000 times 100,000 equals… you get the picture. Blue Line cannot meet the demand, as their reserves are not large enough.

They petition their friendly banker to extend their credit cash line and he turns them down. He is hearing rumours that they are in trouble.

Blue Line becomes flat line as Mr. CFO sells off every available asset they have to raise their capital base. More rumours spread and good quality assets get bid downward and the slide seems unstoppable for a company with quality ratings and high-grade operations.

Now, just substitute subprime mortgage packages for those young men, and credit default swaps for the premiums paid… while multiplying that effect by millions and millions.

In these unprecedented times for investor citizens, we do need to know whether these and other alternative strategies have been used in one's personal investment holdings.

Why? The more you learn about your investments, the more financially literate you become and the more comfortable you will feel about planning for your future financial security now. The obvious: not understanding your own finances, leads to having no control over attaining future goals. You become the slogan much articulated. Those who fail to plan; will almost always plan to fail.

The challenge is where to start? The answer: Start with what you know and build on the basics from there.

Here is a checklist of some contingency items for your initial focus.

Savings and term deposits:

How much have you saved?

What are the rates?

How are they calculated?

Do you know how to compare the rates between various currencies, then convert them to your local currency?

Maximizing income:

If your employment situation looks unsettling, can you think of two other ways to bring in extra income quickly? If you can't, think about exploring those options now.

Appreciating assets:

Take a quick asset count. How many purchases have you made in the last year are worth more now than when you bought them? None, 1-3, 4-10, 11-15?

If your answer is less than ten, ask yourself if you still get enjoyment from these things, are they necessary, and if not, why did you buy them?

Spending:

Can you apply that same philosophy to your spending habits?

Does it really matter whether you have the latest shoes, or bag, as long as you advance in your career?

Can you save that money instead, or better yet, invest in further education?

Employee benefits:

When was the last time you reviewed this book to fully understand what your company will (and will not) cover or provide for you. Hint. Most people have no idea.

Life can be unexpected. What would you do if disaster hit?

Do you have a slush fund?

Do you have life insurance?

Are your children protected in your will, if you cannot care for them?

Investments:

Back to the beginning. Do you know how your investments are allocated?

What they are invested in?

How much do they cost you?

What kind of risk they take on to achieve performance?

Do they use leverage to boost the returns?

We live in unsettling times. We cannot control the world, but we can take control of our own little universe.

There is no time like the present to plan for your future. Start now.

The first part of financial planning is setting goals. Make your first goal becoming financially literate about all of your investments. Use www.360financialliteracy.org.

Be sure to follow the First Financial Planning Week Program October 6-12 and the AFL composite family as they work through the challenges in managing their finances and their lives.

Martha Harris Myron CPA -NH1929, CFP® -67184 (US licences) TEP — Society of Trust and Estate Practitioners. She is a Senior Wealth Manager at Argus Financial Limited, specialising in comprehensive financial solutions and investment advisory services for individual private clients and their families, business owners, endowments and trusts. Direct Line: 294-5709. Confidential e-mail can be directed to mmyron@argusfinancial.bm The article expresses the opinion of the author alone. Under no circumstances is the content of this article to be taken as specific individual investment advice, nor as a recommendation to buy/sell any investment product. The Editor of the Royal Gazette has final right of approval over headlines, content, and length/brevity of article.