Credit Default Swaps: Pros, Cons, Crises, Examples

The Insurance Product That Nearly Destroyed the Global Economy

Credit default swaps
Credit default swaps led to the 2008 financial crisis. Photo: Spencer Platt/Getty Images

Definition: Credit default swaps (CDS) are contracts that insure against default of municipal bonds, corporate debt, and mortgage-backed securities.  Banks, insurance companies, and hedge funds sell them. They collect a premium for providing the insurance. 

Here's how it works. A company issues a bond, which is the same thing as asking for a loan from whoever buys the bond. Several companies purchase the bond (lend the money), but want to make sure they don't get burned if the company goes bankrupt.

They buy a credit default swap from a third party, which guarantees the bond.

Pros 

Like any insurance policy, swaps allow companies to buy protection against an unlikely but devastating event. That enables them to fund riskier ventures than they might otherwise. That spurs innovation and creativity.

Companies that sell swaps protect themselves with diversification. That way, if one company or even industry defaults, they have the fees from other successful swaps to make up the difference. Swaps provide a steady stream of payments with little downside risk. (Source: Forbes, Credit Default Swaps Are Good for You, Oct. 20, 2008)

Cons

Swaps were unregulated until 2009. When the bond defaulted, there was no regulator to make sure the seller of the CDS had the money to pay the holder. In fact, most financial institutions that sold CDS only held a small percentage of what they needed to pay the insurance.

That meant they were undercapitalized.

When banks sold CDS as insurance, the system worked fine. That's because most of the debt did not default. Unfortunately, the CDS gave a false sense of security to bond purchasers. They bought riskier and riskier debt because they thought the CDS protected them from any losses.

Dodd-Frank

In 2009, the Dodd-Frank Wall Street Reform Act required the Commodity Futures Trading Commission (CFTC) to regulate swaps. It specifically required a clearinghouse be set up to trade and price swaps.

Many banks shifted their swaps overseas to avoid U.S. regulation. Although all G-20 countries agreed to regulate them, many are at least two years behind the United States in finalizing the rules.

The JP Morgan Chase CDS 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 Wal-Mart. When the trade started losing money, many other traders began taking the opposite position, hoping to profit from JPMorgan's loss. (Source: Reuters, JP Morgan Future Losses at the Mercy of an Obscure Index, May 17, 2012; New York Times, JPMorgan's Trading Loss Is Said to Rise at Least 50%, May 17, 2012)

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 debt-to-GDP ratio was higher than the European Union's 3% 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% 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. However, the International Swaps and Derivatives Association ruled that the CDS must be paid, regardless. (New York Times, Greek Credit Default Swaps Are Activated, March 9, 2012; Credit Default Swaps)

The 2008 Financial Crisis

By mid-2007, there was more than $45 trillion invested in swaps. That's more than the money invested in U.S. stock market ($22 trillion), mortgages ($7.1 trillion) and U.S. Treasuries ($4.4 trillion) combined. In fact, it was almost as much as the economic output of the entire world in 2007, which was $65 trillion.

Even worse, banks used them to insure complicated financial products. They included poorly-understood mortgage-backed securities (MBS) and collateralized debt obligations (CDOs). They traded swaps in unregulated markets. The buyers had no relationships to the underlying assets. That meant they didn't understand the risk inherent in these derivatives.

As the value of underlying assets fell, and the insurance had to be paid, the value of the swaps fell. That caused the demise of AIG, which had an $11 billion CDS write-down. Other companies that were hard hit were Swiss Reinsurance Co., MBIA and Ambac Financial Group Inc. The breakdown of the CDS market meant less ability to get insurance for loans. As a result, banks became less likely to make loans. Also, they realized they needed to hold more capital, and become more risk-averse in their lending. That cut off a source of funds for small businesses and home loans. These were both large factors that kept unemployment at record levels. In this way, CDS contributed to the 2008 financial crisis. (Source: Time, Credit Default Swaps: The Next Crisis?, March 17, 2008.)