Credit Default Swap

What Is A Credit Default Swap?

A credit default swap (CDS) is a financial derivatives contract that acts as an insurance policy that an investor takes out in order to protect against a bond issuer defaulting on its obligations to pay interest and repay principal.

The investor "swaps" their risk with an insurance company, a bank, or a hedge fund. The institution accepts the risk against the bond, defaulting in exchange for a premium, which is usually paid quarterly. If no default occurs, the seller of the swap keeps the premium income. If a default does occur, the seller is obligated to pay the buyer the bond's principal and any interest due.

Investors also use CDSs as a way to speculate on a bond issuer's financial health and their likelihood to default.

Role In 2008 Financial Crisis

CDSs have been blamed for exacerbating the 2008 financial crisis. At the time, the CDS market was unregulated and very large. Several insurance companies—notably American International Group (AIG), then one of the largest in the world—had sold CDSs against a bond default by Lehman Brothers, which prior to the crisis seemed like a fairly safe bet.^[1]

However, when Lehman failed in September 2008 at the height of the debacle, burdened by a large portfolio of subprime mortgages and other high-risk securities, AIG was unable to hold up its end of the CDS bargain, dragging it down with Lehman. AIG was subsequently bailed out by the U.S. government, an unprecedented event. The government had bailed out commercial banks before, but never a private insurance company.^[2]

The presence of CDSs may have given bond investors a false sense of security, inviting them to take on more and more risk in the belief that their investments were covered by the companies that sold the swaps. However, that proved to be false in the case of AIG and other companies that couldn't make good on all the swaps they had written.

After the crisis, the Dodd-Frank Wall Street Reform And Consumer Protection Act was passed into law by the U.S. Congress and mandated that the CDS market be regulated by the Commodity Futures Trading Commission and the Securities and Exchange Commission.^[3] In addition, the Volcker rule prohibited banks from investing in derivatives, including swaps, using customer deposits.

Marketplace Function of CDS

Despite the negative publicity they received as a result of AIG's near-collapse, CDSs do provide a useful marketplace function.

For example, they enable young, high-risk companies to tap the bond market to fund their operations at a lower cost than they otherwise might by protecting investors who buy their bonds. Likewise, CDSs help spread the risk among various investors, from those who own the bonds outright to those willing to write the swaps, thus lowering borrowing costs.^[1]

The CDS market is very large. According to the U.S. Comptroller of the Currency, the total outstanding at the end of 2018 was US$3.7 trillion. However, that is a small amount compared to the US$45 trillion that was invested in swaps in 2007, prior to the financial crisis.

Summary

Credit default swaps are derivative financial contracts that basically act as insurance against a bond default. Investors essentially swap the credit risk on a bond with an insurance company, bank, or hedge fund, which takes on the risk that the bond issuer will meet their obligations in exchange for a premium. CDSs also enable investors to speculate on the relative riskiness of individual bonds and issuers.

CDSs received a bad reputation during the global financial crisis, when American International Group, a large insurance company, was unable to cover the swaps it had written to insure the debt of Lehman Brothers, which failed and dragged down AIG with it. AIG was subsequently bailed out by the U.S. government, which then passed a law regulating the CDS market.