Understanding Credit Default Swaps is Understanding the Meltdown

We’ll hear a lot of talk about the reason for the current economic meltdown during tonight’s debate between Senators John McCain and Barack Obama. There will be talk about regulation and deregulation, who did what to or for or against Fannie Mae and Freddie Mac, who could have prevented what. And, hopefully, we’ll hear a bit about Credit Default Swaps. Because while there may be many reasons for the markets’ current ails, Credit Dafault Swaps (or “CDS’s”) is clearly a leading culprit.

The problem is that understanding what they are and how they work is challenging, to say the least. For those who want to understand the nuances of what will no doubt be an erudite and idea-focused debate, understanding CDS’s is important. Fortunately, there are some resources that can make them a bit less opaque.

The best explanation of what CDS is and why they matter was on This American Life. On Sunday, the NPR radio show offered “Another Frightening Show About the Economy.” Act Two focused on Credit Default Swaps and, through examples and straightforward language, actually made them understandable. I highly recommend giving them a listen.

Matthew Phillips at Newsweek explained not only how Credit Default Swaps work, but how they came into being. The article is appropriately entitled, “The Monster That Ate Wall Street.”  Back in March, Janet Morrissey at Time magazine described CDS’s back in an article prophetically titled, “Credit Default Swaps: The Next Crisis?”  Not surprisingly, Wikipedia has an entry on Credit Default Swaps, too.

Again, “This American Life” does the best job of putting an understanding of CDS’s in reach for most of us. For those willing to risk it, however, here’s my understanding:

Company A loans $1 billion to Borrower B. There’s a small risk that Company B won’t make good on the loan, so Company A goes to Insurer C and buys a Credit Default Swap. For a percentage of the face value each year, Insurer C agrees to pay off the loan to Company A if Borrower B defaults (let’s use 10% as the cost of the CDS). This sounds like a good deal to Company A so they pay the premium. Insurer C is going to make $100 million a year so long as Borrower B doesn’t default.

Then the economy gets rough and the risk of Borrower B defaulting has gone up. Insurer C gets nervous and seeks a CDS of it’s own from Insurer D. Insurer D is willing to take on the risk, but it wants a higher premium for the higher risk — let’s say 15%. Since Insurer C probably has lots of CDS’s lying around, passing off the risk on some of them makes good financial sense. There’s nothing stopping Insurer D from reselling the CDS. In fact, what actually happened is that most company’s playing in this rarified altitude, bought and sold lots of these Credit Default Swaps. In fact, the value of the CDS’ grew to be 10 times the value of the loans they insured against.

The problem is that at the end of the road, someone was left holding the “ultimate” CDS. When you unravelled all the buying and selling, someone was obliged to pay someone else if some other guy defaulted. The most amazing fact: because Credit Default Swaps are contracts between two parties and are not regulated by any government, no one really knows how many of these things are floating around out there.

When the defaults started flowing in, a lot of these ultimate Credit Default swaps were held by AIG, the world’s largest insurer. When it couldn’t make good on its obligations, the dominoes were threatening to fall. That’s why the Department of the Treasury bailed out AIG. This house of cards was about to fall and the $85 billion was the glue intended to keep it standing.

Fair warning, this is my interpretation only and should not be confused with the facts. I make no warranty that what I explained here is really right. I do guarantee it’s an oversimplification. I strongly advise you to take a look (or listen) to the resources listed above. It’ll make listening to the debate, assuming they do get around to substance, a bit more comprehensible.

Post Debate Notice: OK, Credit Default Swaps didn’t come up even once in the debate. So much for my predictive powers. But, it’s good to know about these things in case you’re ever trapped in an elevator with someone and you run out of interesting things to talk about.

Another Post-Posting Notice: erdosfan was kind enough to offer some corrections and clarifications on this post. To see his comment, please click on the “comment” link, below.

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2 Responses to “Understanding Credit Default Swaps is Understanding the Meltdown”

  1. Jason Says:

    Do you have a Private mortgage insurance (PMI) policy? If you do have one your PMI insurer passes their risk to others by bundling 100 policies together and selling them as a credit default swaps (CDS). They do this in order to protect themselves by large payment to mortgage providers such as insurers in the event your home is repossessed. In the mortgage industry this has been the case for decades. If you bought a PMI to protect your lender then you are building the CDS market. To avoid this put at least 20% down on your home or pay what it takes now to get rid of the PMI policy. http://nomedals.blogspot.com

  2. erdosfan Says:

    Dear Alan Katz,

    With all due respect, this article is factually incorrect on a number of points.

    Yes, AIG indirectly (through trusts) issued credit default swaps. But AIG was not a swap dealer. AIG was a financial guarantor. Swap dealers are fully hedged market players and comprise the bulk of CDS trades. The reason AIG failed was because it was not hedged at all. It applied the financial guarantor business model to the CDS market, and did so with disastrous results.

    http://derivativedribble.wordpress.com/2008/10/23/systemic-counterparty-confusion-credit-default-swaps-demystified/

    “The problem is that at the end of the road, someone was left holding the “ultimate” CDS. When you unravelled all the buying and selling, someone was obliged to pay someone else if some other guy defaulted.”

    >>Yes, but again, swap dealers (who hold the largest positions in the market) are on both sides of these trades, so they usually don’t lose or gain much. They profit from playing the role of middleman. Moreover, a CDS is a zero sum game: if you lose money I gain money, so the net effect is zero.

    “The most amazing fact: because Credit Default Swaps are contracts between two parties and are not regulated by any government, no one really knows how many of these things are floating around out there.”

    >>Also, not so. The Bank of International Settlements frequently issues studies on the estimated size of the CDS market.


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