Credit Default Swaps: Taking the Default Out of Your Portfolio
Ah, Credit Default Swaps: you can't live with them, but you can't live without them. Why? Well, besides the fact that they make up $10.2 trillion of the global economy (a wee-bit more than the Gross Domestic Product of India), it's because they are the insurance of the financial markets--and who doesn't love insurance?
A Credit Default Swap, or CDS, is basically an insurance contract that is most commonly purchased to hedge bond purchases. A CDS has three main players: the investor (AKA-CDS purchaser), the bond issuer, and the CDS writer. When an investor wants to lend money (AKA-credit) to a company, municipality, etc. (in other words, buying their bonds), they are exposed to the risk of the issuer experiencing some type of credit event. Credit events are when an issuer's change in financial position, or outlook, leads rating agencies to change their credit rating. This change can be incremental; their rating can change from a AAA to a AA+. Or, it can be in the form of a total default--which is when the company throws in the towel and gives up on paying their debt obligations (kind of like what every college student would love to do).
The biggest need for a CDS is in the latter case (thus default being in the name). When an issuer defaults, the investor is left holding a possibly worthless security, only reassured by the hope that either the company will come back from the grave, or that they'll be thrown a bone during the liquidation of assets. In a CDS, the writer (usually an insurance agency or big bank) will, for a fee, give the investor the peace of mind that they'll still get their money in the case of default.
When a CDS contract is written on an underlying asset, let's say We Hate Profit Inc.'s 10 year bond, the asset's creditworthiness is no longer tied to that institution. In other words, no one cares if We Hate Profit Inc., who has a B- credit rating, defaults if the bonds are backed by Big Bank Inc., who has a AAA rating because, at the end of the day, the money is ultimately backed by a AAA institution. This also works in the converse, where the CDS writer has a lower rating and the security then has a lower rating, but that's not particularly common.
You might be thinking, "If a company has a bad credit rating, why invest in their bonds to begin with?" Just like everything in finance, it's all about capturing whatever spread possible. To begin with, let's look at who would buy CDSs (and other repackaged securities). Pension funds and money market funds operate by a strict set of investment rules due to the fact that they are either holding people's livelihoods or alleged to be extremely safe, respectively. Since they have to be careful stewards of their investor's money, they need to look for the safest investments that will bring the greatest yield. Remembering that the markets are underpinned by the concept of risk and reward, these funds would have to look to the riskiest securities for the highest reward, right? Exactly.
Let's take Lot's of Fun(ds), a pension fund for the North American Clown Union. LOF needs to return a certain percentage to their investors each year, so they start looking in the high-yield bond area and find our buddies at We Hate Profit Inc., who are paying 8% on their 10 year bond. Unfortunately, LOF can't invest in B- bonds, so they turn to Big Bank Inc. who will "insure" the bonds for 4% of the value, thus turning it into a AAA bond. Voila! LOF has a AAA bond that pays 4%, 0.25% over what the other AAA bonds pay.
Seems great, right...?
...well, most of the time.
From Cash to Crisis
As I mentioned earlier, the CDS market today is about $10.2 trillion, which is pretty significant, seeing as though it's as large as the third highest producing country in the world. However, in mid-2007, the CDS market was over $57 trillion--almost as large as the global GDP. What's worse is that many of these CDS's were insuring mortgage-backed securities (MBS), which were the least understood security on the market at the time.
MBSs are derivative securities that take a group of mortgages from a bank, package them together, and sell packs to investors. MBSs package the mortgages of people with low credit ratings with those who have high credit ratings in order to create a security with a "good" average rating. While seemingly harmless, in the approximately 18 years running up to the crisis, mortgage requirements were becoming much more relaxed--a product of the Community Reinvestment Act of 1977 and federal pressure on mortgage lenders to loan to "subprime" borrowers (not particularly great credit) in the 1990's. The combination led to a boat-load of "toxic" mortgages being pumped into the system, which institutions (like Big Bank Inc.) slapped CDSs onto, and investors (like HOF) bought up like no tomorrow--after all, housing prices could only go up, right?
Well...as the housing bubble began to burst, housing prices started to fall--putting people "underwater" on their mortgages (AKA- they owed more on the mortgage than their house was worth). As people began to default, CDS writers had to start paying out on their own contracts. The eventual waterfall of defaults led to the Federal Government bailing out big players like AIG (who had $11 billion in CDS debt), the bankruptcy of Bear Stearns, Lehman Brothers, and Merrill Lynch, and the purchasing of $426 billion of distressed debt by the U.S. Treasury under the Troubled Asset Relief Program (TARP). Why? Because the banks, who were "too big to fail," had failed to acknowledge the possibility of all of the swaps going bust at the same time.
The lesson of the day? The law of large numbers does not apply when everything is on fire.