Credit Default Swaps

May 29, 2017 | Barcelona, ​​Spain

I believe credit default swaps to be one of the more challenging concepts to understand from this course. Essentially, they are insurance contracts to cover losses on certain securities should they default. They can apply to municipal bonds, corporate debt and mortgage securities and can be sold by financial institutions such as banks and hedge funds. In a swap, the buyer of the insurance pays premiums over a period of time and in turn is secured should they need to default. I think of it as being similar to buying home insurance to protect against unexpected events such as fire and theft.

The idea for CDS is simple enough and should benefit both parties, however as shown by the 2008 credit crisis, they can be too good to be true. Although the banks and insurance companies are regulated, the credit default swap market lacks real regulation. This mean that before 2008, many buyers and sellers were trading from investor to investor without anyone regulating the trades to ensure that the seller could cover the losses should they occur as a result of default. Investors were trading these swaps with each other without rules or regulations, so when the inevitable large defaults occurred, often times the resources necessary to cover them did not exist.

This made it incredible difficult for banks to value the insurance contracts and securities to add on to pre-existing struggles with valuing mortgage-related securities. Some of the top commercial banks including JP Morgan Chase, Citibank, Bank of America and Wachovia were four of the most active in this market. They heavily invested in CDS because they were seen as easy money with a booming economy and few CDS at the time, making them a low-risk way to collect premiums. This kept expanding till it grew out of control, entering the secondary market where investors and hedge funds would rely on speculation to buy and sell CDS instruments without regulation. This all came to a head when the economy tanked and the providers of the insurance did not have the financial resources necessary to cover the immense losses. Insurance companies were scrambling to find anything liquid to cover the losses, but there simply was not enough money. Without regulation, many of the CDS’s had gone through as many as 30 trades, so when the defaults occurred finding those responsible for covering the losses was increasingly difficult.

Much like burst of the housing bubble, the economic crisis of 2008 all seems to be traced back to a lack of regulation and accountability not only by the government, but by the large financial institutions trusted with people’s money. Investors hold some responsibility in knowing where they invest their money, but banks and other financial corporations hold majority of responsibility in understanding the risks they take on. It seems that with something as risky as the stock market, when things are too good to be true, they probably are. People are always looking for ways to win big in the market, but those large winnings investors seeks always come at a cost.

Sources:

  1. http://www.investopedia.com/terms/c/creditdefaultswap.asp
  2. https://www.oroyfinanzas.com/2013/05/que-cds-credit-default-swaps/
  3. https://www.elblogsalmon.com/conceptos-de-economia/que-son-los-credit-default-swaps
  4. http://www.nasdaq.com/article/dtcc-to-launch-blockchain-credit-default-swaps-reporting-in-early-2018-cm794771
  5. https://www.nytimes.com/2016/03/22/business/dealbook/credit-default-swaps-make-restructuring-more-difficult.html
  6. https://www.nytimes.com/interactive/2015/business/dealbook/credit-default-swaps.html
  7. http://www.economist.com/blogs/freeexchange/2013/01/credit-default-swaps?zid=300&ah=e7b9370e170850b88ef129fa625b13c4
  8. https://www.theguardian.com/business/2010/mar/09/question-answer-credit-default-swaps
  9. https://www.theguardian.com/business/2012/may/14/jp-morgan-loss-credit-default-swap
  10. https://www.theguardian.com/commentisfree/2017/apr/27/barack-obama-powerful-voice-paid-speeches
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