Please read the information below to get a better understanding of what credit default swaps are.
The starting point is asking the question, what do you pay for when you borrow money?
1.The right to use the money now rather than later
2.The risk and cost of you defaulting
3.The effort of issuing and administrating the loan
Loan issuers often don’t like to take up all three roles and therefore have designed financial instruments to offload risk exposure and to free capital. The two major instruments used during the financial crisis were Credit Default Swaps (CDS) and Collateral Debt Obligations (CDO). This page will focus on Credit Default Swaps.
A Credit default swap is a sophisticated name for a type of insurance. The buyer pays premiums for the insurance to the seller. The buyer and seller are called counter parties. A credit default swap (CDS) is an agreement that the seller of the CDS will pay the buyer in the event of a loan default. The buyer of the CDS makes regular payments to the seller and, in exchange, receives a payment if the loan defaults. Corporate and government bonds are insured in this way.
Why would anyone buy a CDS? Mainly for hedging a bet and speculation.
The value of most CDS ranges from $10-$20 million and maturity ranges typically from 1 to 10 years. They grew in popularity prior to the beginning of the financial crisis as indicated by the dates below.
– Outstanding CDS
2003 = $ 3.7 trillion
2007 = $62.2 trillion
2010 = $26.3 trillion
2012 = $25.5 trillion
2015 ~ $16 trillion
Although they are similar to insurance, CDS do have some differences. Some of them are listed below.
- Anyone can buy and sell them – even unregulated entities
- CDS cannot simply be canceled
– Seller is not required to maintain reserves to cover a potential loss. While insurance companies maintain reserves and can rely on law of large numbers, in CDS market risk management often occurs through buying further CDS
- Buyer is not required to disclose potential risks
- CDSs are not traded on an exchange and there was no required reporting of transactions to a government agency prior to 2014.
Here is an example:
Goldman Sachs loans Lehman Brothers $1 billion. Lehman Brothers gives Goldman Sachs a Bond which equals $1 billion and Lehman Brothers receives $1 billion in cash.
Goldman Sachs insures the $1 billion bond with an insurance company – AIG. Goldman Sachs pays AIG $10,000 per month for the insurance.
Goldman Sachs hedges the risk of default by Lehman Brothers. AIG promises to pay Goldman Sachs $1 billion if Lehman defaults, i.e., if it does not pay back the $1 billion.
Problem: Goldman Sachs does not know what the risk is that AIG will default on promise to pay the $1 billion if Lehman defaults.
The seller of credit default swaps is positioned like a property insurance company with a lot of exposure along the Gulf Coast. Most of the time, the seller just collects premium income.
However, if a severe hurricane strikes, the losses could be very large. AIG has the risk that Lehman Brothers will default while Goldman Sachs has the risk that AIG will default on the CDS in case Lehman Brothers will default – EXCTLY WHAT HAPPENED!
AIG was bailed out by US government to the tune of $186 Billion (but ultimately the government made a nice profit with this bailout). But the AIG bailout was mainly a bailout of the banks who were paid as a consequence of the bailout: Goldman-Sachs. The problem that the bailout exposed was systemic risk. Each debtor plans to withdraw funds at the first sign of trouble. Such plans are incompatible, because if all depositors attempt to do the same they cannot all succeed (not enough money for everyone). When the institution’s creditors panic it cannot roll over its short-term funding and the institution collapses. With domino effects, the contagion spreads from one firm to another.
The information on this page was based on a powerpoint presentation given by Dr. Volker Grzimek