Understanding credit default swaps

By the time this article is published, 16 years will have passed since the 2008 financial crisis. The crisis had a profound impact on financial markets and unveiled the fragility of the data-driven economic system that was once considered well-informed.

Although I have a background in computer science, I was drawn towards the nuances that caused the financial crisis. There were myriad of new concepts to explore like MBS, CDO, credit ratings etc. Which I found relatively easy to grasp except for CDS (credit default swaps) and the whole betting debacle surrounding it. Hence, I wrote this article for any curious leaner to easily understand CDS. Even if you don’t need it for an economics class, you’ll be able to finally make sense of the famous casino scene in the movie Big Short.

What is a CDS

Taken at its base value, a CDS is like an insurance contract against the risk of a debt default.

Let’s break this down with a simple example. Imagine the following scenario,

• You (Protection Buyer) have provided a loan to your dodgy brother in law at the request of your wife.
• Although you love your wife, you don’t fully trust her brother to be financially responsible. To safeguard yourself against the risk of him defaulting on a loan (i.e., fail to repay the loan), you enter into a CDS agreement with your bank (often a financial institution like a bank or insurance company), which serves as the Protection Seller in this scenario
• Your bank agrees to compensate you if your brother in law defaults on the loan. This is known as the payout. If the credit event (loan default) occurs, the protection seller compensates you, usually by paying the difference between the loan’s face value and its market value after default.
• In exchange for this protection, you pay your bank a periodic fee, known as a premium, for the duration of the loan.

If, by the end of the loan period, your brother in law got his act together and fully repaid the loan, the premiums you paid would have been in vain. But it might have helped you sleep better at night. On the other hand, if your brother-in-law defaulted on the loan, the bank would have provided you with a substantial payout as compensation.

Why is it called a swap?

One aspect that confused me while reading about CDS was why it was termed a “swap.” Upon further reading, here’s what I found.

In the context of a CDS, the “swap” refers to the exchange of cash flows between the two parties:

1. The Protection Buyer agrees to make regular payments (premiums) to the Protection Seller over the life of the contract.
2. The Protection Seller agrees to make a payment (a lump sum) to the Protection Buyer if a credit event (like a default) occurs.

So, while a CDS doesn’t involve swapping assets directly, it involves a swap of cash flows: regular premiums in exchange for a potential payout upon a default event.

This structure is similar to other types of swaps, like interest rate swaps or currency swaps, where two parties exchange streams of payments based on different financial instruments or rates. The term “swap” reflects the idea that both parties have ongoing financial obligations to each other, which they “swap” over time.

Betting on CDS (naked CDS)

Before we get into the nitty gritty of the 2008 crisis, there’s one more concept we need to fully understand: the naked CDS. At first glance, A CDS seems like a relatively benign instrument with a limited potential for harm, but a naked CDS has the power to turn it into a ticking time bomb.

Let's expand on the earlier scenario to explain this:

Original CDS:

• You lend $1 million to your brother in law. You buy a CDS from Bank ABC to protect against the risk that he might default. You pay Bank ABC a premium of $10,000 per year.

Naked CDS:

• Your mutual friend Alice, who has no connection to your loan with your brother in law, believes that he is likely to default. Maybe she knows about his lavish lifestyle more than you do. She buys a CDS from Bank CDE, betting that he will default. However, Alice doesn’t own the loan and has no direct exposure to the original loan’s credit risk.
• Alice’s friend Bob hears about this and decides to get in on the action as well and does the same thing with Bank DEF, buying another CDS on the same loan.

Now, multiple CDS contracts exist on the same loan. Only you, the original lender, actually own the underlying debt. The others (Alice, Bob, etc.) are speculating.

Here’s the twist, imagine Dan: who is a mutual contact of Bob, who chooses to buy a CDS on Bob’s CDS, instead of the original loan. Essentially, he’s betting on the outcome of the Bob’s bet. If the bet succeeds and Bob receives the payout, Dan will also receive a similar payout from the bank that he used as the protection seller.

This creates a situation where a seemingly unrelated group of parties becomes closely interconnected, all tied to the outcome of a single debt.

Why is this problematic:

The total amount of CDS contracts could far exceed the value of the underlying loan. For instance, if your $1 million loan has $10 million worth of CDS contracts written on it, the potential payouts in case of a default could be enormous, multiplying the impact of a default far beyond the original loan.

2008 Crisis Context:

• Leading up to 2008, CDS contracts were widely used to bet on mortgage-backed securities (MBS), many of which were tied to subprime mortgages (home loans offered to borrowers with poor credit histories, typically at higher interest rates, due to the increased risk of default).
• As housing prices fell and mortgage defaults increased, the value of MBS plummeted, leading to massive payouts on CDS contracts.
• Financial institutions like AIG had sold huge amounts of CDS and couldn’t cover the losses when the defaults started happening, leading to a crisis of confidence and liquidity in the financial markets.

Why did the banks agree to these!?

There’s nothing more attractive to a bank than steady regular payment of cashflows and CDS contracts provided that. It seemed like a low-risk way to generate income at the time. For instruments with a good credit rating (AAA) banks would charge less premiums and instruments with low credit rating (think B, CC) would command higher premiums.

The housing market was not expected to collapse and AIG and many others underestimated the risk of widespread defaults, particularly in the subprime mortgage market. They didn’t foresee the scale at which these defaults could occur, nor did they fully appreciate how interconnected and leveraged the financial system had become through these CDS contracts.

Synthetic CDOs

This article wouldn’t be complete without addressing the infamous synthetic CDOs.

A CDO (Collateralised Debt Obligation) is a type of financial product that pools together various loans and other forms of debt, such as mortgages, bonds, or other assets, and then slices this pool into different tranches or layers. Each tranche is sold to investors based on its level of risk and return.

On top of regular CDOs, there were synthetic CDOs, which didn’t actually hold any real assets. Instead, they were made up of credit default swaps and other derivatives that essentially bet on the performance of other CDOs or loans. This created additional layers of risk and further amplified the financial instability during the crisis.

CDOs played a significant role in the financial crisis, but a detailed exploration of them falls beyond the scope of this article.

Conclusion

CDS contracts became famous and widely used because they appeared to offer a way to earn high returns with seemingly low risk, while also providing a tool for speculation.

However, the underlying issues — such as the poor quality of many mortgages, the complexity of financial products, and the lack of adequate risk assessment — were not fully understood or acknowledged by most market participants.

While a few saw the impending collapse, the majority did not, leading to the catastrophic financial crisis when the housing market did indeed crash.