A credit default swap (CDS) is a financial derivative that guarantees against bond risk. It allows one lender to "swap" its risk with another.
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.
Most of these swaps protect against the default of high-risk municipal bonds, sovereign debt, and corporate debt. Investors also use them to protect against the credit risk of mortgage-backed securities, junk bonds, and collateralized debt obligations.
How Credit Default Swaps Work
Here's an example to illustrate how swaps work. Say 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, so they buy a credit default swap from a third party.
That third party agrees to pay the outstanding amount of the bond if the lender defaults. Most often, the third party is an insurance company, bank, hedge fund, central counterparty, or reporting dealer. The swap seller collects premiums for providing the swap, usually on a quarterly basis.
Pros of Credit Default Swaps
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 innovation hub.
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 of Credit Default Swaps
On the other hand, swaps were largely unregulated until 2010. That meant there was no government agency to make sure the seller of the swap 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, thinking the CDS protected them from any losses.
Protect lenders against risk
Provide a stream of payments
Unregulated until 2010
Gave a false sense of security
How Swaps Caused 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. Treasuries combined. The U.S. stock market held $22 trillion. Mortgages were worth $7.1 trillion, and U.S. Treasuries were worth $4.4 trillion.
Lehman Brothers found itself at the center of this crisis. The firm owed $600 billion in debt. Of that, $400 billion was "covered" by credit default swaps. Some of the companies that sold the swaps were American International Group (AIG), Pacific Investment Management Company, and the Citadel hedge fund.
These companies 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 where buyers had no relationships to the underlying assets. They didn't understand their risks. When they defaulted, swap sellers such as MBIA, Ambac, and Swiss Re 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.
In 2010, the Dodd-Frank Wall Street Reform Act regulated credit default swaps in three ways:
- The Volcker Rule prohibited banks from using customer deposits to invest in derivatives, including swaps.
- It required the Commodity Futures Trading Commission to regulate swaps, specifically requiring a clearinghouse to be set up to trade and price them.
- It phased out the riskiest credit default swaps.
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, when the European Economic Area regulated swaps with the MiFID II.
The JPMorgan Chase Swap Loss
On May 10, 2012, JPMorgan Chase CEO Jamie Dimon announced the bank lost $2 billion betting on the strength of credit default swaps. By December 31, 2012, the trade had cost $6.2 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. JPMorgan Chase first introduced credit default swaps in 1994. It wanted to insure itself against the risk of default on the loans it held on its books, but these products ultimately led to some of its greatest losses.
The Greek Debt Crisis and CDS
Swaps' false sense of security also contributed to the Greek 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 60% limit. 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 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.