When credit default swaps are in the news, it’s usually a sign that something has gone haywire in the markets. These derivatives, known as CDS, are similar to insurance that pays out if a company or country defaults on its debt. Investors often use them as a hedge because they offload default risk to a third party. For example, CDS can also be used for speculation, to bet on a borrower melting down.
Warren Buffett once famously called these and other sophisticated derivatives “weapons of mass financial destruction,” foreshadowing the outsize role CDS linked to mortgages would play in the 2008 to 2009 financial crisis. A series of bank troubles in March sent lenders’ CDS surging as more parties sought to protect themselves against the possibility of a financial company defaulting. Soon after, one CDS trade tied to Deutsche Bank triggered a global market selloff.
1. What’s a credit default swap?
CDS are a type of derivative, a contract whose value is derived from price movements of an underlying financial asset, index or instrument. In this case, the value is tied to the risk that a company or country will default on its debt. A buyer of a credit default swap receives a payout from the seller if a borrower fails to make good on its obligations.
2. How do credit default swaps work?
Purchasers of a credit derivative, usually debt investors, make payments to a seller, who provides a payout if a borrower fails to make good on its obligations. If the borrower skips an interest payment or fails to pay the debt, the International Swaps and Derivatives Association, a trade group, determines if the swap pays out.
See also: Asian REITs – A good addition to your investment portfolio in 2024
3. What are they used for?
Derivatives can be used as hedges — tools for reducing risk — or making bets. A lender might want to insure against a default by buying a credit default swap that would pay off if the loan went sour. With the advent of credit default indexes two decades ago, CDS investors had an easier way to bet on market movements. CDS tied to those indexes are now the most liquid credit derivatives in the market.
4. How have CDS gotten investors into trouble?
See also: Comparing GPU vs CPU in the semiconductor sector
An October 2008 episode of 60 Minutes famously called credit derivatives “the bet that blew up Wall Street,” and George Soros said the instruments are “instruments of destruction” that should be outlawed. Wall Street professionals can debate how prominent a role credit derivatives played in the financial crisis, but CDS contributed to the meltdowns. Traders and money managers used credit derivatives to bet against trillions of dollars of subprime mortgage bonds and related securities, as documented in the book and movie The Big Short. American International Group (AIG) had sold some of that protection, and as the US housing market deteriorated, it had to post more and more collateral on its positions. Those collateral postings and AIG’s losses on other holdings forced the US government to rescue the firm. The Financial Crisis Inquiry Commission, appointed by Congress to investigate the causes of Wall Street’s meltdown, later found that credit derivatives helped amplify the housing crisis.
5. What role have CDS played in the latest bank crisis?
After a run on Silicon Valley Bank prompted regulators to take it over in March, the price to insure the debt of banks of all sizes jumped, though well below 2008 levels, with European banks emerging as a particular point of worry. Investors sometimes see CDS as a measure of fear, so the spike stoked further worries about whether banks were sufficiently capitalised. In this way, CDS prices can sometimes become untethered to the fundamentals and become self-fulfilling — a particular problem for the banking industry, which relies on the confidence of depositors to survive. The European Central Bank said regulators should review the market after the latest turmoil. Regulators have zeroed in on a roughly EUR5 million ($7.2 million) bet on swaps tied to Deutsche Bank junior debt that they suspect kick-started a global selloff in late March. — Bloomberg Quicktake
