How do Credit Default Swaps work?

They have "clouded up the markets with billions of dollars' worth of opaque 'dark matter,' as some economists like to say. Like rogue nukes, they've proliferated around the world and now lie hiding, waiting to blow up the balance sheets of countless other financial institutions" writes Newsweek's Matthew Philips, in a recent article about the history and significance of Credit Default Swaps or CDS.

First, the underlying problem:

There's a reason Warren Buffett called these instruments "financial weapons of mass destruction." Since credit default swaps are privately negotiated contracts between two parties and aren't regulated by the government, there's no central reporting mechanism to determine their value.

The failure of AIG was linked to its CDS:

The country's biggest insurance company, AIG, had to be bailed out by American taxpayers after it defaulted on $14 billion worth of credit default swaps it had made to investment banks, insurance companies and scores of other entities. So much of what's gone wrong with the financial system in the past year can be traced back to credit default swaps, which ballooned into a $62 trillion market before ratcheting down to $55 trillion last week—nearly four times the value of all stocks traded on the New York Stock Exchange.

It all began, explains Newsweek, when some JP Morgan guys made a 1994 trip to Boca Ratan and came up with the concept:

By the mid-'90s, JPMorgan's books were loaded with tens of billions of dollars in loans to corporations and foreign governments, and by federal law it had to keep huge amounts of capital in reserve in case any of them went bad. But what if JPMorgan could create a device that would protect it if those loans defaulted, and free up that capital?

What the bankers hit on was a sort of insurance policy: a third party would assume the risk of the debt going sour, and in exchange would receive regular payments from the bank, similar to insurance premiums. JPMorgan would then get to remove the risk from its books and free up the reserves. The scheme was called a "credit default swap," and it was a twist on something bankers had been doing for a while to hedge against fluctuations in interest rates and commodity prices. While the concept had been floating around the markets for a couple of years, JPMorgan was the first bank to make a big bet on credit default swaps. It built up a "swaps" desk in the mid-'90s and hired young math and science grads from schools like MIT and Cambridge to create a market for the complex instruments.

But it was not until the last few years that the market for CDS took off:

Before long, credit default swaps were being used to encourage investors to buy into risky emerging markets such as Latin America and Russia by insuring the debt of developing countries. Later, after corporate blowouts like Enron and WorldCom, it became clear there was a big need for protection against company implosions, and credit default swaps proved just the tool. By then, the CDS market was more than doubling every year, surpassing $100 billion in 2000 and totaling $6.4 trillion by 2004.

What caused the market for CDS to take off in the early 2000s? Answer: the housing boom. Newsweek expains:

As the Federal Reserve cut interest rates and Americans started buying homes in record numbers, mortgage-backed securities became the hot new investment. Mortgages were pooled together, and sliced and diced into bonds that were bought by just about every financial institution imaginable: investment banks, commercial banks, hedge funds, pension funds. For many of those mortgage-backed securities, credit default swaps were taken out to protect against default.

That was the point when they became traded, as Time's Janet Morrissey explained way back in March 2008:

The CDS market then expanded into structured finance, such as CDOs, that contained pools of mortgages. It also exploded into the secondary market, where speculative investors, hedge funds and others would buy and sell CDS instruments from the sidelines without having any direct relationship with the underlying investment.

"An original CDS can go through 15 or 20 trades," said Miller. "So when a default occurs, the so-called insured party or hedged party doesn't know who's responsible for making up the default and if that end player has the resources to cure the default."

CDS proved useful as a form of insurance against risky housing securities. But, as AIG would discover, CDS are not like ordinary insurance. According to the Newsweek article:

There is no correlation between traditional insurance events; if your neighbor gets into a car wreck, it doesn't necessarily increase your risk of getting into one. But with bonds, it's a different story: when one defaults, it starts a chain reaction that increases the risk of others going bust.

An economic downturn is not like a fire that burns down a house. It's contagious. The premise behind using Credit Default Swaps as a form of insurance was flawed. Which begs the question: why couldn't the Wall Street bankers figure this out?

To return to the AIG bailout, Newsweek explains why it was deemed necessary:

The reason the federal government stepped in and bailed out AIG was that the insurer was something of a last backstop in the CDS market. While banks and hedge funds were playing both sides of the CDS business—buying and trading them and thus offsetting whatever losses they took—AIG was simply providing the swaps and holding onto them. Had it been allowed to default, everyone who'd bought a CDS contract from the company would have suffered huge losses in the value of the insurance contracts they hadpurchased, causing them their own credit problems.

Essentially, AIG was relying upon CDS to insure everybody else. The Newsweek article is helpful, but the arrogance of the bankers quoted in the last paragraph, is hard to fathom.
____
- This is my second post about Credit Default Swaps. My first CDS post is here.
- Picture: CDS pac man from Money Matters blog, his recent posts here.