Credit default swaps (CDS) are securitized insurance products that enable one party to transfer the risk of defaults in debt repayments to another party. These transactions are usually done privately and outside government regulatory control.

The credit default swap market is currently worth more than $50 trillion, more than the market capitalization of many global stock exchanges put together.

How Credit Default Swaps Work

There are three parties to a credit default swap transaction. There is a seller, who sells the credit default swap and guarantees its credit worthiness, and there is a buyer who is supposed to receive credit protection based on the credit guarantees provided by the seller. Then of course there the debtor, whose debt is being sold off and guaranteed by the buyer. The seller’s guarantee states to the buyer that the credit default swap instrument is safe to buy because the owner of the debt is creditworthy and is able to pay when the debt matures.

This is in theory, how everything about the credit default swap is supposed to work but as we shall see later, many of the guarantees were empty as the necessary credit checks that should have been performed on the debt owners were bypassed on the premise of a real estate market that was supposed to keep rising in perpetuity.

Origin of Credit Default Swaps

Sometime in the early 90s, bankers were faced with a mounting problem: how could banks better handle the risk factor involved in giving out huge loans without having to touch the financial reserves that they were required by law to keep in case the loans became non-performing? The answer: package the loans into instruments that could be sold to other investors so as to transfer the risk of performance of those loans to those investors and not to the banks. Thus credit default swaps were created. In essence, the risk of credit default was to be swapped with the new investors purchasing the CDS assets.

JP Morgan took this concept and with the help of young graduates of Cambridge and MIT, was able to create the algorithms of how to transform these loans into instruments that could be traded on the financial markets.

Problems with Credit Default Swaps

Warren Buffett referred to credit default swaps as “weapons of mass destruction” way back in 2003, 5 years before they were implicated as one of the triggers of the subprime mortgage collapse and subsequent global financial crisis. An article by the Guardian UK also hinted at credit default swaps being responsible for the $2billion trading loss incurred by JP Morgan Chase earlier in 2012. They have also been mentioned by both European Commission President Barrosso and market regulators as being aggravating factors in the Eurozone’s sovereign debt crisis.

So what is really the problem with credit default swaps? It essentially boils down to two things: human nature and the very nature of the credit default swaps. The credit default swaps were created knowing that there were bound to be defaults on credit facilities. But what the creators of credit default swaps did not factor in was:

a)    The size of the defaults in the loans on which credit default swaps were based.

b)    The extent of exposure of companies purchasing these credit defaults, and the extent of exposure of other global companies in the firms directly acquiring these CDS assets or providing insurance for credit default swap transactions.

c)     Credit default swaps did not solve the problem of loan defaults. They merely transferred the risk in a magnified manner to others who were by the nature of their operations, unable to mitigate such risk.

d)    The necessary credit checks that were supposed to be carried out to determine who actually qualified to receive some of the subprime mortgage loans that eventually went bad were not done, so as to increase a large pool of people into the market on the hope that the real estate market would just keep rising.

So when every Tom, Dick and Harry in the US began taking loans to buy homes in order to cash in on the boom in prices of real estate that were supposed to keep rising without end, a time bomb was created. As subprime mortgage institutions began giving out loans to people who had very awful credit and would ordinarily not have qualified to be given loans, the risk of defaults were increased and the buck was simply passed on to other investors. Companies like the American Insurance Group (AIG) which provide insurance for many global firms, took on so much of the credit default swaps that when the cards came crashing down, the US government had to bail the company out to prevent a major global financial collapse.

By the time home prices went up so much that prices became prohibitive and the demand dropped off, the inevitable happened. Prices crashed, and people who never had the right credit in the first place were now stuck with paying off loans on property that was worth much less in value than they originally got them for. Meanwhile, guarantees on these loans had been given by the sellers of the credit default swaps on this market, and buyers were left with uncovered exposure to a falling market. In 2007, the bomb exploded, and it was only in 2008 that the global extent of exposure was revealed, triggering the collapse of Bear Stearns and Lehman Brothers and the global financial crisis.

These events showed clearly, that credit default swaps should be used only when a proper system of credit checks, credible credit ratings by the relevant agencies and proper regulation of this market is all in place to prevent the abuses of the past.