Credit Default Swaps

Understanding Credit Default Swaps

9 min read

The confusingly named credit default swap, a CDS, is not so much a swap as an insurance policy. The person who buys the swap is essentially betting against a financial product (often a bond), hoping it will fail. We’ll dive into detail on how it caused an economic crisis and how we can avoid that in the future.

Credit default swaps were created in 1994 by Blythe Masters from JP Morgan Bank. Credit default swaps are insurance against default risk. The CDS market was originally formed to provide banks with the means to transfer credit exposure and free up regulatory capital. 

Today, the market’s major drivers are the rise in demand for cash alternatives and the availability of affordable and low-cost credit swap facilities. They became popular in the early 2000s, and by 2021, the value of the outstanding credit default swaps stood at $8.5 trillion.

5-Second Takeaway

  • A credit default swap (CDS) is a contract that allows two or more parties to transfer the credit risk associated with fixed-income products. Investors buy credit default swaps for protection against a default.
  • In a CDS, one party “sells” risk, and the counterparty “buys” that risk.
  • The fixed payments made from CDS buyer to CDS seller are customarily set at a fixed annual rate of 1% for investment-grade debt or 5% for high-yield debt.
  • CDSs are designed to cover many risks, including defaults, bankruptcies, debt restructuring, and credit rating downgrades.
  • The hazard rate or the probability of default is an essential determinant of the value of the expected payment.
Credit Default Swaps

Insurance Against Non-Payment

A credit default swap is issued as insurance against non-payment. Through a CDS, a buyer mitigates the risk of their investment. More specifically, a CDS enables the buyer to shift all or a portion of their risk onto an insurance company or another CDS seller. Like most things, a CDS doesn’t come free; the buyer must pay a recurring fee. In this way, the buyer of a credit default swap receives credit protection, whereas the seller guarantees the creditworthiness of the debt security

In the most basic sense, the buyer of a credit default swap is entitled to the value of the contract by the seller of the swap should the issuer, for whatever reason, default on payments.

If the debt issuer doesn’t default, and if all goes well, the CDS buyer loses some money. However, the buyer will lose much more if the issuer defaults and they don’t buy a CDS. As such, the more the holder of a security thought its issuer was likely to default, the more desirable a CDS is, and the more the premium was worth it.

Let’s say you are a bank, for example, and you’ve given millions of dollars in loans to hundreds of thousands of people. For 25 years, you expect all those borrowers to give you the money back plus interest. However, some people might lose their jobs and be unable to repay the borrowed money. To counteract this risk, you can buy a credit default swap, which acts as insurance against a potential default. 

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Credit Default Swap Parties

The global credit default swap market is segmented based on type, end-user, and region. Based on type, the market is divided into municipal bonds, emerging market bonds, mortgage-backed securities, corporate bonds, and others.

A typical credit default swap involves three parties. The buyer, the seller, and the borrower – the person taking out a mortgage, for example. 

Let’s call the buyer party A, the seller party B, and the borrower party C. C takes out a loan from party A, and they promise to pay it back monthly plus interest. 

However, A thinks C might default later because they take out a loan for 25 to 30 years. It’s highly unpredictable if they will be able to pay it back. More importantly, A wants to be safe, so they buy a CDS from party B. Remember, B is the seller of a CDS, and A is the buyer of the CDS. Essentially, A bought insurance on party C’s defaulting. 

Nothing Is Free

This isn’t going to come for free. Hence, B gets a monthly payment or a premium from A for agreeing to take on any risk. So what B is doing by giving A a credit default swap is that they’re saying if C defaults or if C struggles to pay A any money at all, B will cover it. 

The bet B is taking is that C doesn’t default. Hence, they receive all A’s premium payments and don’t have to cover the cost of C defaulting. 

So what’s the rationale A is taking to justify it’s the bet they are taking? A is saying, ok, if C defaults if they don’t pay me my money, I will get covered by B. 

The modeling of a credit default swap price is based on the probability of default and the recovery rate given a credit event happens.

Stock Market vs. Credit Default Market

Did you know that before the 2007-08 financial crisis, more money was invested in the credit default market than in the stock market? At that time, a staggering \$45 trillion was invested in the CDS market, whereas only \$22 trillion was in the stock market. This shows how big these investments are and how many people are betting on them. 

Interesting Facts

  • $2.7 Billion in Credit Default Swaps Blew Up One Day Before the Fed Launched Its Repo Loan Bailouts in 2019
  • A known $41 billion in Credit Default Swaps (CDS) on Russian debt exists. The biggest question is, what banks and institutions are on the hook to pay it?
  • CDS was Big Short traders’ main vehicle to short the subprime mortgage market. Notably, they are how traders like Steve Eisman, Michael Burry, and Greg Lippman made their fortunes.

Biggest Credit Default Swap in History

Many investment banks found themselves entangled in the 2007-08 financial crisis. Unfortunately, the Lehman brothers found themselves the biggest casualty during that time.

To put it in perspective, the Lehman brothers owed $600 billion in debt, with $400 billion in credit default swaps! As you can imagine, their insurance company couldn’t cover that debt, so the Federal Reserve had to step in and bail them out. 

How did Credit Swaps contribute to the financial collapse? They caused it!

Banks make a lot of money underwriting swaps upon swaps upon swaps. In fact, for every dollar of coverage, Lehman Brothers had underwritten $32 worth of leverage on that $1 buck. 

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Different Types of Credit Default Swaps

Typically, the credit default swap market has three sectors:

1. Single-credit CDS 

Where the underlying instrument is a reference obligation or a bond of a particular issuer (i.e., specific corporates, bank credits, and sovereigns.)

2. Multi-Credit CDS

This is a CDS in which the underlying reference is more than one name (reference entity, reference asset, reference obligation, etc.). This swap protects a combination of credits (names) instead of a single credit name. 

Have I confused you yet?

Simply put, it is insurance on a reference portfolio with several entities. The protection buyer pays a regular premium proportional to the current notional amount of the swap.

One example is a basket credit default swap. In this scenario, the credit event is defined as the default of a specific combination of credits within a basket. 

3. CDS Index

This CDS is based on underlying debt obligations known as reference entities. Market makers typically issue credit default indexes to seek protection from the buyers of such swaps. The market makers determine an index spread as the annual rate the buyers (investors) would receive regularly. A fixed set of equally weighted credit default swaps with standard maturities ranging between 5 to 10 years.

Final Thoughts: Credit Default Swaps

Credit default swaps (CDS) pose several risks to institutions and markets, many of which are not unique. CDS were used primarily by institutional investors in the past, but in recent years, their use has become more widespread.

CDS is marred in controversy as some believe it can be used to make speculative bets on the likelihood of a company or country defaulting on its debt. This was one of the factors that contributed to the global financial crisis of 2008-2009. 

Frequently Asked Questions

Big name banks that traded CDS's had to declare bankruptcy when many of their swaps were defaulted. As a result, it sent the US into an economic recession.

Banks, insurance companies, and pension funds are some of the largest holders of CDS's. They typically use them as hedges.

During the housing crisis of 2008, Michael Bury made upwards of $100 million buying up mortgage bonds. Goldman Sachs was the bank he bought them through. 

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