Counterparty Risk Explained

To the common person there is much in the public media that is not clearly stated, mostly because we do not know the meaning of financial industry jargon. There are buzzwords that have specific meanings to the trained business person who deals with finances for a profession just like any industry. Financial wizard Warren Buffett in his personal letters to his shareholders refers to such a term in relation to the current financial recession in America; it is the term Counterparty risk.

The recent financial crisis that has brought about the current state of recession nationally resulted from what the financial industry calls a liquidity crisis. The term liquidity crisis is defined as this; when companies, investment firms and banks or the people running them suddenly do not have the money needed to pay back the money that is owed. Therefore the backing for the investments is no longer in their possession, let alone any supposed profits or principles that were gained from the initial investments.

On the investor side of the financial crisis comes what is called Counterparty risk. Counterparty risk is term for the potential risks taken by an investor on the opposite side of the contract. The risk taken by persons or companies, that they have entrusted their money to may actually not live up to contractual obligations or promised outcome. In the case of Wall Street most investors were taken by surprise that there was a problem with their financial institution and by then it was far too late to do anything about it. Taking someone to court in a civil case with no money is about the same result as trying to sue the Counterparty risk corporation, just the level of losses are more substantial. The result is almost the same; you cannot get blood from a turnip. As I resurrect an old quotation.

You cannot get something from accounts that are holding nothing. That is a hard fact for the situational victims of Counterparty risk like has happened to the United States of late.

This was a problem for independent investors but also major financial corporations that had contracts with the big Wall Street brethren. When entering into contracts with the bigger fish of the corporate world, most trusted in the established reputations as clout for their market stability. None of these investors or companies entertained the idea of Lehman Brothers or Bear Sterns being unable to produce the money entrusted to them. Losses are a potential hazard of investment but not complete loss of all capital investment. Let alone every last cent. This was the lesson of Counterparty risk.

The fall of AIG, Bear Stearns, and Lehman Brothers are examples of Counterparty risk in action. The AIG Bailout, along with other banks like Goldman Sachs caused by a contractual interdependence on one another that was not watched. There was no check and balance system that guaranteed that AIG would have the money for pay outs, so there was not a set aside budget allotted for them. Goldman was in a Counterparty risk stalemate with AIG, since the money was owed by AIG but there now was none. Thus the government bailout was to cover the AIG deficit to major inventors with holdings such as Goldman Sachs.

The public has been conveniently steered away from understanding this in the media for the most part.