Few financial products have a worse reputation than the credit default swap. Before 2008, almost nobody outside Wall Street had heard of one. Afterward, they were blamed for helping turn a housing slump into a global crisis. The idea behind them is simple: a credit default swap is insurance against a borrower failing to repay.
How a CDS Works
A credit default swap, or CDS, is a contract between two parties. The buyer makes regular payments to the seller, much like insurance premiums. In exchange, the seller promises to compensate the buyer if a specific borrower, such as a company or a government, defaults on its debt. Imagine a pension fund that owns $10 million of a company’s bonds. It can buy a CDS on that company. If the company keeps paying, the fund has spent only the premiums. If the company defaults, the seller covers the loss. The product was developed by bankers at J.P. Morgan in the 1990s.
Hedging and Speculating
Used this way, a CDS is a sensible tool for managing risk. A bank can keep lending to a customer while passing some of the danger to someone more willing to carry it. There is an important difference from ordinary insurance. A person cannot insure a neighbor’s house, but an investor can buy a CDS on bonds they do not own. That turns the contract into a bet that a borrower will fail. Because many investors can bet on the same debt, the total value of the swaps can be many times larger than the debt itself.
A Market Signal
The price of a CDS, called the spread, is closely watched. It reflects how likely investors think a default is. When the cost of insuring a company’s or a country’s debt rises sharply, it is an early warning that the market sees trouble, often before credit rating agencies react.
The Role in 2008
By 2007, the CDS market had grown to roughly $60 trillion in contracts. Most were private deals with no central record, so no one knew who owed what to whom. The insurance company AIG had sold enormous amounts of protection on securities tied to U.S. mortgages, without setting aside enough money to pay claims. When those securities collapsed, AIG could not meet its obligations. Because so many banks depended on its promises, the U.S. government stepped in with a rescue that began with an $85 billion loan. Afterward, regulators required most standard swaps to pass through central clearinghouses and be reported.
Conclusion
Credit default swaps let lenders protect themselves and give markets a running estimate of who is likely to default. Those are useful functions. The events of 2008 showed what can happen when insurance is sold without the resources to honor it. A promise to cover losses is only as good as the party making it, and risk that is transferred is not risk that has been removed.