Credit Default Swaps with their Pros, Cons, and Examples

How a Boring Insurance Contract Almost Destroyed the Global Economy

Credit default swaps
••• Photo: Spencer Platt/Getty Images

A credit default swap is a financial derivative that guarantees against bond risk. Swaps work like insurance policies. They allow purchasers to buy protection against an unlikely but devastating event. Like an insurance policy, the buyer makes periodic payments to the seller. The payment is quarterly rather than monthly.

Most CDS protect against default of high-risk municipal bondssovereign debt, and corporate debt. Investors also use them to protect against the credit risk of mortgage-backed securitiesjunk bonds, and collateralized debt obligations

Example

Here's an example to illustrate how swaps work. A company issues a bond. Several companies purchase the bond, thereby lending the company money. They want to make sure they don't get burned if the borrower defaults. They buy a credit default swap from a third party, who agrees to pay the outstanding amount of the bond. Most often, the third party is an insurance company, bank, or hedge fund. The swap seller collects premiums for providing the swap. 

Pros 

Swaps protect lenders against credit risk. That enables bond buyers to fund riskier ventures than they might otherwise. Investments in risky ventures spur innovation and creativity, which boost economic growth. This is how Silicon Valley became America's innovative advantage.

Companies that sell swaps protect themselves with diversification. If a company or even an entire industry defaults, they have the fees from other successful swaps to make up the difference. If done this way, swaps provide a steady stream of payments with little downside risk.

Cons

Swaps were unregulated until 2009. That meant there was no government agency to make sure the seller of the CDS had the money to pay the holder if the bond defaulted. In fact, most financial institutions that sold swaps were undercapitalized. They only held a small percentage of what they needed to pay the insurance. The system worked until the debtors defaulted.

Unfortunately, the swaps gave a false sense of security to bond purchasers. They bought riskier and riskier debt. They thought the CDS protected them from any losses. 

The 2008 Financial Crisis

By mid-2007, there was more than $45 trillion invested in swaps. That was more than the money invested in the U.S. stocks, mortgages, and U.S. Treasurys combined. The U.S. stock market held $22 trillion. Mortgages were worth $7.1 trillion, and U.S. Treasurys were worth $4.4 trillion. In fact, it was almost as much as the $65 trillion produced by the entire world.

Credit default swaps on Lehman Brothers debt helped cause the 2008 financial crisis. The investment bank owed $600 billion in debt. Of that, $400 billion was "covered" by credit default swaps. That debt was only worth 8.62 cents on the dollar. The companies that sold the swaps were American International Group, Pacific Investment Management Company, and the Citadel hedge fund.

They didn't expect all the debt to come due at once. When Lehman declared bankruptcy, AIG didn't have enough cash on hand to cover swap contracts. The Federal Reserve had to bail it out.

Even worse, banks used swaps to insure complicated financial products. They traded swaps in unregulated markets. The buyers had no relationships to the underlying assets. They didn't understand their risks. When they defaulted, swap sellers like Municipal Bond Insurance Association, Ambac Financial Group Inc., and Swiss Reinsurance Co. were hit hard.

Overnight, the CDS market fell apart. No one bought them because they realized the insurance wasn't able to cover large or widespread defaults. They accumulated capital and made fewer loans. That cut off funding for small businesses and mortgages. These were both large factors that kept unemployment at record levels.

Dodd-Frank

In 2009, the Dodd-Frank Wall Street Reform Act regulated credit default swaps in three ways. First, the Volcker Rule prohibited banks from using customer deposits to invest in derivatives, including swaps. 

Second, it required the Commodity Futures Trading Commission to regulate swaps. It specifically required a clearinghouse be set up to trade and price them.

Third, it phased out the riskiest CDS. 

Many banks shifted their swaps overseas to avoid U.S. regulation. Although all G-20 countries agreed to regulate them, many were behind the United States in finalizing the rules. But that changed in October 2011. The European Economic Area regulated swaps with the MiFID II.

The JP Morgan Chase Swap Loss

On May 10, 2012, JP Morgan Chase CEO Jamie Dimon announced the bank lost $2 billion betting on the strength of credit default swaps. By 2014, the trade had cost $6 billion. 

The bank's London desk executed a series of complicated trades that would profit if corporate bond indexes rose. One, the Markit CDX NA IG Series 9 maturing in 2017, was a portfolio of credit default swaps. That index tracked the credit quality of 121 high-quality bond issuers, including Kraft Foods and Walmart. When the trade started losing money, many other traders began taking the opposite position. They hoped to profit from JPMorgan's loss, thus compounding it.

The loss was ironic. JP Morgan Chase first introduced credit default swaps in 1994. It wanted to insure itself from the risk of default on the loans it held on its books.

The Greece Debt Crisis and CDS

Swaps' false sense of security contributed to the Greece debt crisis. Investors bought Greek sovereign debt, even though the country's debt-to-gross domestic product ratio was higher than the European Union's 3 percent limit. That's because the investors also bought CDS to protect them from the potential of default.

In 2012, these investors found out just how little the swaps protected them. Greece required the bondholders to take a 75 percent loss on their holdings. The CDS did not protect them from this loss. That should have destroyed the CDS market. It set a precedent that borrowers, like Greece, could intentionally circumvent the CDS payout. The International Swaps and Derivatives Association ruled that the CDS must be paid, regardless.