Credit Default Swaps (CDS) Defined
What Are Credit Default Swaps?
Credit Default Swaps (CDS) are financial derivatives which transfer the risk of default to another party in exchange for fixed payments.
It can be thought of as a form of insurance for issuers of loans.
A “credit default” is a default or inability to pay back a loan.
The “swapping” takes place when an investor “swaps” their risk of net getting paid back with another investor or insurance company.
How Do Credit Default Swaps Work?
To swap their risk of default, the buyer of a CDS makes periodic payments to the seller until the credit maturity date.
In the agreement, the seller commits that, if the loan issued by the buyer of the CDS defaults, the seller will pay the buyer all premiums and interest that would’ve been paid up to the date of maturity.
Just like an insurance policy, a CDS allows purchasers to buy protection against a default on their outstanding loans.
Credit Default Swap Example
Let’s look at an example.
A company raises money by issuing bonds.
A bank purchases the bonds in exchange for interest paid by the company to the bank, but bonds carry a risk of defaulting.
To decrease risk, banks may buy a CDS from an insurance company.
If the bonds default, the insurance company must pay the bank the principal and all interest payments that would have been paid.
Who Created CDS?
Credit default swaps are said to be created by Blythe Masters of JP Morgan in 1994.
They gained immense popularity in the early 2000s.
By 2007, the outstanding credit default swaps value stood at $62.2 trillion – more than the total amount invested in the stock market, in mortgages, and in U.S. Treasuries combined.
Unfortunately, there was no regulatory framework to regulate credit default swaps, which became a growing concern for investors.
CDS Leads To Financial Crisis
This all came to a head during the financial crisis of 2008.
While many banks were involved, Lehman Brothers investment bank stands out as the greatest casualty as it owed $600 billion in debt, $400 billion of which was covered by credit default swaps.
American Insurance Group, the bank’s insurer, lacked the funds to clear Lehman Brothers’ debt, so the Federal Reserve stepped in to bail out both Lehman Brothers and AIG.
The Dodd-Frank Wall Street Report Act of 2009
In light of this, the Dodd-Frank Wall Street Report Act of 2009 was formed to regulate the CDS market.
It eventually banned the riskiest swaps and kept banks from using customer deposits to invest in credit default swaps.