Credit default swap
A credit default swap (CDS) is a form of insurance on a financial instrument such as a bond. It is a way of managing risk that turned into something else entirely.
It's basically insurance. But it turned into gambling.
A more formal definition
Like all derivatives the credit default swap (or CDS) is priced upon an underlying asset or pool of assets. In the case of a CDS the underlying asset is often a bond, however it can be other credit instruments such as loans as well.
The CDS allows the owner of credit instruments to transfer the risk of an adverse event such as default, bankruptcy, or a downgrade, without transferring ownership of the underlying asset. Essentially when you buy or sell a CDS, you are buying or selling the risk. The buyer of the CDS is buying protection for their asset (selling risk), while the CDS seller is selling protection (buying the risk). The protection buyer of the CDS makes periodic premium payments to the protection seller while the protection seller pays the buyer a set value of the asset only if the prescribed adverse event as listed in the specific CDS contract occurs. In practice the set value of the asset is often par value of a bond.
An informal example
Managing by transferring
The idea behind insurance is to transfer the risk of something bad happening to you, where, if it does happen, you are badly hurt, to someone else to whom it would not be as big a problem if the same event happened.
For instance, suppose you have a house worth $200,000 and you are afraid of what would happen if it burned down. Well, you would be out $200,000 and a place to live. Both not good. So, you buy some fire insurance for, say, $4,000 per year (expensive, maybe, but this is just an example). Now, if your house burns down, you will be paid by the insurance company $200,000, so you won't be out the money and you can use that to buy a new house, so you still have a place to live.
In other words, you have transferred the risk of major disaster to you, to someone else -- the insurance company. They are willing to do this, because lots of people are paying them for similar things and the chance of all those bad events happening all at the same time is very low. You might be the only one with a burned-down house that year and they've got lots of customers. Their risk is spread out.
In essence, you have sold the risk of something bad happening, to someone else. You pay that person a premium and they'll make you whole if the bad event actually does happen. You've managed your risk.
Same thing with a credit default swap. Except instead of a house, you've got, say, a $200,000 bond from Lehman Brothers. And you're worried about not getting back the money you've loaned Lehman in case they default. So you go to someone else and ask how much it would cost for them to insure it. They tell you 2% a year. You say great, pay the $4,000 premium every year, and now if Lehman goes bust, that person owes you $200,000. You've swapped the risk of Lehman going into default.
One minor change, though. $200,000 is nothing in these kinds of transactions. $1 billion is a lot more common and the 2% premium comes out to $20 million per year. Now it looks interesting.
Changing into gambling
So far, nothing's wrong. You've got a bond in a stable long-lived company and you've got insurance in case the unthinkable happens. But the next step makes it even more interesting. Let's go back to the houses.
What if Bob, the guy down the street, thinks your house looks pretty good, but he is worried too that it could burn down. So he buys a fire insurance policy on it under the same terms. He pays $2,000 each year so that, if the house burns down, he'll receive $200,000. Jack, his friend, does the same thing. As does Joe, Roger, and Henry. But their motivation is different. You bought the insurance because you're afraid of the risk of fire and what that would mean to you. They just want to see your house burn down so they get paid. You are insuring. They are gambling.
A few years ago, the same thing started happening with CDSs. Remember that $20 million that you paid? Pretty good money for insuring against something that wouldn't happen, right? So that person says that he's willing to insure other people for the same thing. Pay me $20 million a year and, if Lehman defaults, I'll pay you $1 billion. Are you willing Bob, Jack, Joe, Roger, and Henry? How about you, Sue, Anne, Denise, and Barb? Woo hoo! I just made $200 million. What's that? I'm on the hook for $10 billion if Lehman goes into default? Big deal! Lehman's rock solid.
What that person who just made $200 million has done is leverage his assets. It is highly unlikely that he has $10 billion in cash lying around to pay out in case Lehman defaults. More like $1 billion. That's enough to cover your CDS, but all he got was a 2% return. Pitiful. Now, though, he's used his small asset base to boost his return into something respectable. $200 million. Just like a lever can turn a little bit of force into a powerful mover, this leveraging has turned his small asset base into something that returns a lot of money, some 20% per year. He's "leveraged" at 10-to-1. As long as nothing happens, that's great.
Suppose Bob is the manager of a small hedge fund. And he's bought one of those CDSs on Lehman for $20 million. But the price, the premium, is dependent on how risky Lehman's bonds are viewed as being. A bit of time has passed and a couple of rumbles have come out of Lehman (must have eaten something that disagreed with it). Now the price is 3%. So Bob sells a CDS for that and is paid $30 million. What he's just done is set up a hedge. He's on the hook for $1 billion if Lehman goes down, which he doesn't have (he's leveraged his $100 million) for which he is paid $30 million, but he gets $1 billion if Lehman goes down, for which he is paying $20 million. Net effect is he receives $1 billion which he turns around and sends on, except that he gets to keep the $10 million difference in premiums, at no risk.
Unless the person who would owe him $1 billion doesn't pay. Answer? More CDSs!
And around and around we go.
- The market for CDSs is unregulated, unlike for true insurance such as that fire policy. Insurance companies are not allowed to put too much of their money at risk so that they can pay their customers if and when. CDS markets have no such brakes.
- Many, even the majority, of the CDSs lack adequate collateralization. That is, there is nothing backing them up. The first CDS sold above is backed up by the $1 billion of assets held by the company. But the next nine (to Bob, Sue, et al.) were not. So what happens if they all come due at once?
- CDSs are widely criticized as being too complex to value their risk properly. Basically, the CDS has whatever terms the buyer and seller agree to and that can be complex indeed. The more complex they are, the more ways risk can creep in without being properly evaluated. That leads to improper pricing (that is the seller might not be compensated enough for the risk taken on).
- Due to the inter-related nature of the hedging (and everyone does it to spread risk out even further), the whole thing becomes dependent on one link in the crisscrossing chains. If Lehman fails, for instance, which it did in Sept. 2008, all of a sudden, many CDSs become due and the ones who had to pay out usually don't have the money to cover all their obligations. Leverage turns against the companies involved and the whole fabric begins to unravel.
Credit default swaps are used by banks and insurance companies in an effort to manage and lessen their credit risk. Financial companies support the CDS market as it allows them greater flexibility in managing their risks.
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