Credit default swaps (CDS)
What are they?
Well, the easiest way to see a CDS is as a form of insurance, in particular a form of insurance against the issuer of a bond that you own defaulting.
Let's say you buy a five-year bond valued at $100 from company X. X promises to pay you your $100 in five years' time and to pay interest on the bond in the meantime. But if X goes bankrupt before the five years are up, you'll get nothing. It's to ensure against this eventuality that you buy a credit default swap in X.
How does it work? Well, you first find someone (usually a bank) who will sell you a CDS contract on company X. Put very simply, that seller will then take into account considerations such as the likelihood of X defaulting and the amount that the owner of the bond is likely to get if a default does happen.
Based on these considerations, the seller will come up with a price for the CDS and will ask you to make regular payments to them (again, a bit like an insurance contract) to cover against default. If X defaults, they'll pay you the money you've lost on that bond.
The price of a CDS is typically given in the form of basis points (1/100th of 1%) above the rate that would be paid on a more simple form of swap that only takes into account company X's cash flows and the interest rate.
If a CDS in X stands at 100 basis points, it will cost $100k to insure against default on $10m of X's debt.
Like bonds themselves, credit default swaps can be bought and sold on the open market. You could, for example, buy a CDS in X from another bond investor who'd set one up previously.
The market for CDS is HUGE. According to Charles R. Norris, author of the Trillion Dollar Meltdown, the notional value of credit default swaps - ie, the size of investor portfolios covered by them - grew from $1 trillion in 2001 to $45 trillion in mid-2007. Current estimates put it closer to $62 trillion in value.
What have they got to do with the financial crisis?
CDS were originally conceived as a way of insuring against the risk of a company defaulting on its bonds, but they've taken on a dual function as the credit crunch has taken hold - they're also a way of speculating whether a company (or bank) is about to go bust.
If a company is thought to be about to default on its debt, the cost of a related CDS will rise dramatically. This is unsurprising, given the danger that the CDS will actually have to pay out. By comparison, if a company's credit quality improves the cost of a CDS will typically decline.
As a result, the value of CDS is often seen as an indication of the problems facing a company - and in particular the problems facing a bank. For example, in the weeks before Bear Stearns went under, CDS in the bank rocketed from 246 points to 792 points.
Because the CDS market is so huge, there are fears that if a big default were to happen, there would be serious problems for the financial system as a whole. It doesn't help that the back-office system for dealing with the paperwork associated with the CDS market is antiquated and contracts related to buyers and sellers are often out of date.
It was partly for this reason that the US Federal Reserve stepped in to save AIG.
Lehman Brothers, however, was allowed to fail. Once Lehman defaulted, issuers of the $400bn of Lehman CDS - many of which were hedge funds - were obliged to pay 91% of the total value to the CDS owners. In order to access this cash, many hedge funds were forced to sell equities and other liquid assets, and there were fears that this would lead to meltdown in the equity markets.
In fact, the settlement of Lehman's CDS went quite smoothly.
Instead, with global recession looming, attention was focused on the huge cost of paying out on CDS covering the debt of companies like airlines or builders if they also went into default. By mid-October 2008, the Financial Times pointed out that it costs €914k a year to insure €10m worth of debt for the next five years - a total payout of more than €4.5m, almost half the value of the debt to be insured.
Last updated on 7 September 2009.
