What are Credit Default Swaps?

A ‘Credit Default Swap’ is a fairly simple concept hiding behind an overly complicated name – something the finance industry seems to do particularly well.

As a deadly combination of insurance and gambling, it's the financial weapon of mass destruction that nearly brought the world economy to its knees in 2008.

Credit Default Swaps

A credit default swap (CDS) is similar to an insurance agreement.

In insurance, you own a house and insure it against fire damage. You pay the insurance company a premium each year, and if your house burns down, they pay for the cost of a new one.

A CDS is when an investor pays a premium to the insurance company insuring against a ‘financial fire’ – a borrower going into default (unable to make their loan repayments).

It’s handy for investors who have invested in bonds (fixed-interest investments where the money is lent out to provide an income).

If the borrower at the other end can’t pay the money back (causing the bond to go into default), the investor doesn’t lose their money because the insurance company pays out the value of the investment.

It all sounds pretty reasonable.

However, here’s where the problems creep in.

Although it looks like an insurance arrangement, CDS are neither a form of insurance nor governed by its rules.

The buyer of the ‘insurance’ doesn’t actually need to own the bond they are protecting.

In insurance, you have to own the house to have it insured. That way, you don’t really want the house to burn down because any gain from an insurance payout is cancelled out by the fact that you’ve lost your house.

In contrast, with a credit default swap anyone can take out ‘insurance’ against a default.

It’s essentially a bet. The buyer is saying to the insurer, “I bet you US$100,000 dollars that this bond will go into default this year. If it does, you pay me $10 million. If it doesn’t, you keep the $100,000.”

This means multiple buyers can place bets on the same bond default, making it a highly dangerous event.

But during the 2000s the insurers didn’t see it as dangerous. They just happily saw the millions in premium payments coming in.

As far as they were concerned, even if a borrower couldn’t afford to pay their money back, the lender could repossess the house, sell it, and get more money than they had originally lent out.

Why? Because house prices always go up. So there would be no actual bond default, and no need to pay out.

The problem was that a lot of bonds were backed by sub-prime mortgages – mortgages the borrower could not reasonably afford because they had borrowed too much or had no job.

And America’s excess borrowing had also created a property bubble, the bursting of which would cause a drop in property values.

All in all, these sub-prime mortgage bonds were defaults waiting to happen. And between 2005 and 2007, market players quietly began realising this.

They started buying credit default swaps, gambling on the fact that some kind of sub-prime mortgage crisis was coming – and with it a huge payout.

By the end of 2007, the total CDS market for all debts had reached $63 trillion – four times the size of the US economy.

Sure enough, in 2008 Americans started defaulting on their home mortgages and the bond investments defaulted. At that point, the CDS claims started pouring in.

But paying them was the problem. Swaps are not governed by insurance rules, so providers of credit default protection – be it banks or insurance companies – had no limits as to how much they could insure.

Indeed, many had grossly over-insured. Two famous companies that had sold too much protection were insurance giant AIG and investment bank Lehman Brothers.

They had both over-committed to paying out more than their own market value.

This is why Lehman Brothers collapsed (as well as its fellow investment bank Bear Stearns) and why AIG needed an $80 billion cash bailout from the government.

Much of this bailout went straight into paying its CDS claim obligations (including $12 billion to Goldman Sachs, who was last week charged with selling the mortgage bonds while also betting against them).

In fact, much of the government’s bailout efforts were aimed at clearing up these CDS claims to get money flowing again.

During the financial storm, Wall Street didn’t know who was exposed to CDS obligations, bringing lending between banks virtually to a standstill, and drying up money for businesses.

Now last week, at the same time as the Goldman bombshell, President Obama announced he was turning his attention to new rules for banking so this wouldn’t happen again.

Creating rules for these credit default swaps, and other glorified gambling, is said to be high on his agenda.

By The Casual Truth