Credit Default Swaps Explained

Credit Defaults Explained

We wrote about derivatives in our last post and in our derivatives timeline. In this post, we’ll delve into the most pernicious iteration of derivatives: credit default swaps. Credit default swaps can serve as a form of insurance, but they also allow traders to bet on whether a firm or a country (e.g. Greece) will default on its debt. In such cases, Trader A bets that the firm or country won’t default and Trader B bets that it will. Trader B makes regular, small payments to trader A, unless the default occurs, in which case trader A makes an enormous payout to trader B. It’s a gamble.

One of the biggest problems with this picture is that the traders don’t have to own stake in what they’re betting on. In other words, it’s as though someone were able to take out car insurance on a car they didn’t own, with the hunch that the person who owned the car was going to get in a wreck. You can see why this is bad: The person who made the bet would have the incentive to wreck the owner’s car in order to get a payout.

The credit default swap market has dropped considerably since the peak of the crisis, but it’s still around 2006 levels (nearly $30 trillion), meaning that if defaults started occurring regularly, we might see enormous payouts (and market confusion) once again. This market is among those that deserve serious attention.

Here are some additional explanations/quotes about credit default swaps:

Excerpt from Crisis Economics

A derivative is simply a bet on the outcome of some future event: a movement in interest rates, oil prices, corn prices, currency values, or any number of other variables. They go by various names—swaps, options, futures—and they’ve worked just fine for decades, enabling people to “hedge” against risk. In their original iteration, farmers could hedge against fluctuations in the prices of their crops in advance of a harvest, giving them peace of mind they would otherwise lack.

But in recent years derivatives have grown into something altogether different, thanks to the rise of new varieties, such as the credit default swap (CDS). … In these cases, purchasing a CDS was akin to buying homeowners’ insurance on a house that you didn’t actually own—and then trying to set fire to it. … The CDS market grew from next to nothing to astonishingly large.

Excerpt from The Great American Stickup

[Hank] Paulson in his memoir offers a rare admission of how shallow was the understanding also of the key bankers, like those at Goldman Sachs, who were trading in the suspect derivatives with such abandon. When [President Bush] asked what might trigger the big disruption of the market, Paulson mentioned, “the lack of transparency of these CDS contracts (credit default swaps), coupled with their startling growth rate, unnerved me.”

Excerpt from Griftopia

A credit default swap is just a bet on an outcome. It works like this: Two bankers get together and decide to bet on whether or not a homeowner is going to default on his $300,000 home loan. Banker A, betting against the homeowner, offers to pay Banker B $1,000 a month for five years, on one condition: if the homeowner defaults, Banker B has to pay Banker A the full value of the home loan, in this case $300,000.

So Banker B has basically taken 5-1 odds that the homeowener will not default. If he does not default, Banker B gets $60,000 over five years from Banker A. If he does default, Banker B owes Banker A $300,000.

This is gambling, pure and simple, but it wasn’t invented with this purpose. Originally it was invented so that banks could get around lending restrictions.

For more, see this PBS Oral History about credit default swaps