How a Boring Insurance Contract Almost Destroyed the Global Economy (2024)

A credit default swap (CDS) is a financial derivative that guarantees against bond risk. It allows one lender to "swap" its risk with another.

Swaps work like insurance policies. They allow purchasers to buy protection against an unlikely but devastating event. Like an insurance policy, the buyer makes periodic payments to the seller.

Most of these swaps protect against the default of high-riskmunicipal bonds,sovereign debt,andcorporate debt. Investors also use them to protect against the credit risk ofmortgage-backed securities,junk bonds,andcollateralized debt obligations.

How Credit Default Swaps Work

Here's an example to illustratehow swapswork. Say a company issues abond. Several companies purchase the bond, thereby lending the company money. They want to make sure they don't get burned if the borrower defaults, so they buy a credit default swap from a third party.

That third party agrees to pay the outstanding amount of the bond if the lender defaults. Most often, the third party is an insurance company,bank,hedge fund, central counterparty, or reporting dealer. The swap sellercollects premiums for providing the swap, usually on a quarterly basis.

Prosof Credit Default Swaps

Swaps protect lenders against credit risk. That enables bond buyers to fund riskier ventures than they might otherwise. Investments in risky ventures spur innovation and creativity, which boost economic growth. This is how Silicon Valley became America's innovation hub.

Companies that sell swaps protect themselves withdiversification. If a company or even an entire industry defaults, they have the fees from other successful swaps to make up the difference. If done this way, swaps provide a steady stream of payments with little downside risk.

Cons of Credit Default Swaps

On the other hand, swaps werelargely unregulated until 2010. That meant there was no government agency to make sure the seller of the swap had the money to pay the holder if the bond defaulted. In fact, most financial institutions that sold swaps were undercapitalized. They only held a small percentage of what they needed to pay the insurance. The system worked until the debtors defaulted.

Unfortunately, the swapsgave a false sense of security to bond purchasers. They bought riskier and riskier debt, thinking the CDS protected them from any losses.

How Swaps Caused the 2008 Financial Crisis

By mid-2007, there was more than $45 trillion invested in swaps. That was more than the money invested in the U.S. stocks, mortgages, and U.S.Treasuries combined. The U.S. stock market held $22 trillion. Mortgages were worth $7.1 trillion, and U.S.Treasuries were worth $4.4 trillion.

Lehman Brothers found itself at the center of this crisis. The firm owed $600 billion in debt. Of that, $400 billion was "covered" by credit default swaps. Some of the companies that sold the swaps were American International Group (AIG), Pacific Investment Management Company, and the Citadel hedge fund.

These companies didn't expect all the debt to come due at once. When Lehman declared bankruptcy,AIGdidn't have enough cash on hand to cover swap contracts. The Federal Reserve had to bail it out.

Even worse, banks used swapstoinsure complicated financial products. They traded swaps in unregulated markets where buyers had no relationships to the underlying assets. They didn'tunderstand their risks. When they defaulted, swap sellers such as MBIA, Ambac, and Swiss Re were hit hard.

Overnight, the CDS market fell apart. No one bought them because they realized the insurance wasn't able to cover large or widespread defaults. They accumulated capital and made fewer loans. That cut off funding forsmall businessesand mortgages. These were both large factors that keptunemploymentat record levels.

Dodd-Frank Reforms

In 2010, theDodd-Frank Wall Street Reform Actregulated credit default swaps in three ways:

• The Volcker Rule prohibited banks from using customer deposits to invest in derivatives, including swaps.
• It required theCommodity Futures Trading Commissionto regulate swaps, specifically requiring a clearinghouse to be set up to trade and price them.
• It phased out the riskiest credit default swaps.

Many banks shifted their swaps overseas to avoid U.S.regulation. Although allG-20countries agreed to regulate them, many werebehind the United States in finalizing the rules. But that changed in October 2011, when the European Economic Area regulated swaps with the MiFID II.

The JPMorgan Chase SwapLoss

On May 10, 2012, JPMorgan Chase CEO Jamie Dimon announced the bank lost $2 billion betting on the strength of credit default swaps. By December 31, 2012, thetrade had cost $6.2 billion.

The bank's London desk executed a series of complicated trades that would profit if corporate bond indexes rose. One, the Markit CDX NA IG Series 9 maturing in 2017, was a portfolio of credit default swaps. That index tracked the credit quality of 121 high-quality bond issuers, including Kraft Foods and Walmart. When the trade started losing money, many other traders began taking the opposite position. Theyhoped to profit from JPMorgan's loss, thus compounding it.

The Greek Debt Crisis and CDS

Swaps' false sense of security also contributed to theGreek debt crisis. Investors bought Greeksovereign debt, even though the country'sdebt-to-gross domestic product ratiowas higher than the European Union's 60%limit. The investors also bought CDS to protect them from the potential of default.

In 2012, these investors found out just how little the swapsprotected them. Greece required the bondholders to take aloss on their holdings. The CDS did not protect them from this loss. That should have destroyed the CDS market. It set a precedent that borrowers, like Greece, could intentionally circumvent the CDS payout. The International Swaps and Derivatives Association ruled that the CDS must be paid, regardless.