All you need to know about credit default swaps

Warren Buffett called them “financial weapons of mass destruction”. Now credit default swaps are being blamed for much of the market meltdown. David Stevenson explains what they are and why they matter.

How did credit default swaps start?

Credit default swaps (CDS) are a form of credit derivative, allegedly dreamed up on a JP Morgan “off-site weekend” in 1994. JP Morgan’s books were loaded with tens of billions of dollars in loans to corporations and foreign governments, and by federal law it had to keep huge amounts of capital in reserve in case any of them went bad. The firm’s bankers were addressing “a question as old as banking itself – how to mitigate your risk when you loan money”, says Matthew Phillips in Newsweek. But “what if JP Morgan could create a device that would protect it if those loans defaulted, and free up that capital”?

Credit default swaps: how do they work?

Credit default swaps enable investors, in theory, to cover themselves against default. JP Morgan’s bankers came up with a sort of insurance policy in which a third party assumes the risk of a loan to a customer going bad, and in exchange receives regular payments, rather like policy premiums. So a CDS is created, which removes the risk of that customer defaulting from the bank’s books. JP Morgan built up a “swaps” desk in the mid-1990s and within a few years the CDS became the hot financial product. The market doubled in size each year and spread to cover all grades of corporate and emerging-market debt. And when traders realised they could sell swaps on bonds and other income-producing products they didn’t own and without reserve cover (in other words, without anything to back the insurance), CDS became a big speculative area, too.

So investors piled into the credit default swap market?

They certainly did. But JP Morgan didn’t realise it was creating a monster. The Paulson Troubled Asset Relief Plan (Tarp) has called for $700bn (£400bn) to buy up ‘bad’ assets from bank balance sheets. In comparison, data from the International Swaps and Derivatives Association show that at the end of June, the credit default swap market had a notional value of $54trn. That’s the same as the planet’s 2007 GDP and nearly four times the value of all stocks traded on the New York Stock Exchange. Notional value is the theoretical amount covered – for an entire $54trn to be lost, all asset values would have to fall to zero, which is hardly likely. Even so, this is still a huge market. CDS had a market value of some $2trn in May, according to Moody’s Investor Service, although as CDS are privately negotiated contracts between two parties and aren’t government regulated, there’s no central reporting mechanism to determine their value. More to the point, nobody checks whether institutions selling CDS are able to pay up if they eventually have to. And now that markets are in turmoil, credit derivatives are being widely blamed for making matters a lot worse.

Credit default swaps: where did problems start?

With the US housing boom. As the Fed slashed interest rates and record numbers of Americans piled into property, house prices soared and mortgage-backed securities (MBS) became the ‘must-have’ investment. Subprime mortgages were pooled, sliced and diced into bonds that were bought by just about every financial firm in town, and by banks around the world, too. Credit default swaps were taken out to protect many of these MBS against default. “These structures were such a great deal, everyone and their dog decided to jump in, which led to massive growth in the market,” says Rohan Douglas, ex-head of Salomon Brothers and Citigroup’s global credit swaps research unit in the 1990s. Firms such as the giant US insurer AIG started issuing CDS by the bucket load – $440bn, to be exact. When US house prices nose-dived and MBS values crashed, AIG had to find $14bn to cover its exposure. As the stockmarket sussed out that the insurer couldn’t to do this, its shares collapsed, dragging down the Dow and fuelling a panic that the CDS market was about to fail. So AIG had to be rescued by the US taxpayer.

Credit default swaps: the AIG bailout still hasn’t saved the day?

Not at all. Major institutions are closely linked through credit default swap deals. When one side of a trade defaults, it starts a chain reaction that raises the risk of others losing money. That’s called ‘counterparty risk’, and is partly what has spooked investors into selling off assets and lenders into curbing credit. The collapse of Lehman Brothers has had a particularly big impact. Lehman wrote more than $700bn-worth of CDS. Now it’s gone bust, investors who had taken out these CDS have been left without the insurance, so they’re having to buy more, even though prices are now rising because of the general turmoil. And with investors also buying CDS simply to gamble on whether or not a company will go bust, the impact of a default is far bigger than just the amount of debt and equity a firm has issued. As Gregg Berman at RiskMetrics puts it, “When you… have more people betting, you magnify the impact of a default.”

Credit default swaps: what happens now?

With credit default swaps seen as playing a pivotal role in the financial crisis, the government is itching to regulate. New York State has said it will begin doing so in January and the Federal Reserve Bank of New York hopes to create a ‘clearing house’ to curb market risks, reports Bloomberg. But not everyone agrees. “CDS have been vilified,” says derivatives trader Terri Duhon, “it’s like saying it’s the gun’s fault when someone gets shot.” While swaps have been “dramatically misused, making it a lot easier for some people to get into trouble”, says Stanford economist Darrell Duffie, “they shouldn’t be done away with entirely. If you outlaw them, then the financial engineers will just come up with something else that gets around the regulations”.

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