Credit Default Swaps: Definition, Pros, Cons, Crises
A credit default swap is a financial derivative that guarantees against bond risk. Swaps work like insurance policies. They allow buyers to buy protection against an unlikely but devastating event. Just like insurance, the buyer makes periodic payments to the seller. The payment per quarter instead of monthly.
Most CDs protect against default of high-risk municipal bonds, government debts and corporate debts. Investors also use them to protect against the credit risk of mortgage-backed securities, junk bonds, and collateralized debt obligations.
Here is an example to illustrate how swaps work. A company that has a bond. Several companies purchase the tire, allowing the company to borrow money. They want to ensure that they do not burn if the borrower defaults. They purchase a credit default swap from a third party who agrees to pay the outstanding amount of the loan. Usually, the third is an insurance company, bank or hedge fund. The swap seller collects premiums for providing the swap.
Swaps protect lenders against credit risk. That leaves bond buyers with riskier ventures than they would otherwise finance. The investments in risky ventures spur innovation and creativity, which stimulate economic growth. This is how Silicon Valley became America’s innovative advantage.
Companies that sell swaps protect themselves with diversification. If a company or even an entire industry defaults, they have the cost of other successful swaps to make the difference. If done in this way, swaps ensure a steady stream of payments with little downside risk.
Swaps were unregulated until 2009. That meant there was no government agency to check if the seller of the CDS had the money to pay the holder if the bond was in default. In fact, most financial institutions that sold swaps were undercapitalized. She only had a small percentage of what she needed to pay for the insurance. The system worked until the debtors defaulted.
Unfortunately, the swaps gave a false sense of security to bind buyers. They bought more risky and more risky debts. They thought the CDS protected them from any losses.
The financial crisis of 2008
In mid-2007, more than $ 45 billion was invested in swaps. That was more than the money invested in US stocks, mortgages, and US Treasurys combined. The US stock market held $ 22 trillion. Mortgages were worth $ 7.1 trillion dollars, and the American Treasurys were worth $ 4.4 trillion. In fact, it was almost as much as the $ 6 billion produced by the entire world.
She did not expect all the blame to be due at once. When Lehrman declared bankruptcy, AIG did not have enough money to cover swap contracts. The Federal Reserve had to buy it up.
Even worse, the banks use swaps to insure complex financial products. They are traded swaps in non-regulated markets. The buyers had no relationship with the underlying assets. They don’t understand their risks. When they defaulted swap sellers such as Municipal Bond Insurance Association, Ambac Financial Group Inc., and Swiss Reinsurance Co. heavily hit.
At night, the CDS market fell apart. No one bought them because they realized that the insurance was unable to cover large or widespread defaults. She built up capital and made fewer loans. That cut off financing for small businesses and mortgages. These were both major factors that kept unemployment at record levels.
The Greek debt crisis and CDS
Swaps’ false sense of security has contributed to the Greek debt crisis. Investors bought the Greek government debt, although the country debt-to-gross domestic product ratio was higher than the European Union’s 3 percent limit. The investors also bought CDS to protect them against the potential of the standard.
In 2012, these investors found out how little the swaps protected them. Greece requires bondholders to take a 75 percent loss on their business. The CDS does not protect them against this loss. That must have destroyed the CDS market. It set a precedent that borrowers, such as Greece, would deliberately bypass the CDS payout. The International Swaps and Derivatives Association ruled that the CDS must be paid regardless.