What Credit Default Swaps Are, and How They Contributed to the Housing Bubble and the Worst Recession Since the 1930s

By Charles Kirchofer, Jan. 5^th, 2009

You've probably heard them mentioned in the past year with regard to the housing crisis, the credit crunch, the financial crises, and perhaps even the recession. But what the heck are Credit Default Swaps, and why are they the devil? Well, the short answer is: they're not the devil. The long answer is coming.

Credit Default Swaps (henceforth CDSs) are a type of derivative. What are derivatives? Well, I hope to explain that more fully in a separate article soon, but I'll just say right now that they are financial tools that are designed to protect companies or investors from either market risk (risks that come from fluctuating prices, derivatives against these include forward contracts, futures, and options, which allow buyers and sellers to lock in a given price for something) or credit risk (the risk that someone will default on credit (not pay it back)). CDSs are of the latter type. An explanation with examples is coming, don't worry.

Invented by a group of bankers in 1994, CDSs were supposed to make credit risk easier and more efficient to manage, resulting in higher gains and more stability at the same time (we may laugh now, but for the first several years they did just that, and for more than a decade they seemed to be doing just that and more). How do they work? As always, I like to work with examples:

Company A loans company B $10 million in the form of a 5-year corporate bond (bonds are always essentially just loans directly to something, generally a company or government). Since company B could go under, meaning company A might not get its money back (credit risk), company A cannot rely for its survival totally on getting that money back. If it did, company A would go under if company B did. Obviously not a safe strategy. Before CDSs, the company was required to hold on to a good amount of cash to make sure it could make do if company B (or any other of it's debtors) failed to pay. A CDS allows company A to insure against default. Company A now pays an insurance company, or other CDS supplier, interest (calculated by the insurance company according to the likelihood of company B defaulting) on the principle (the $10 million). Let's say they pay 1.5% a year ($150,000). In the event that company B goes into bankruptcy, the insurance company agrees to buy the now worthless bond from company A for the full $10 million. Thus, the credit risk is transferred to the insurance company, and insurance companies are excellent at assessing risk.

Or are they? Insurance companies are generally exceptionally good at assessing risk in normal situations. The problem is, they were not used to financial risk. If you fall down the stairs, this doesn't usually increase the likelihood that tons of other people around you will suddenly start falling down the stairs, causing a chain reaction. In normal insurance situations, chain reactions are uncommon and limited in scope (your neighbor's house catching on fire could spread to yours or lead to a massive forest fire, but a forest fire in California doesn't make one in Connecticut any more likely). In the financial world, chain reactions are very common due to the interconnectedness of the parties involved. One very large company going bankrupt does increase the risk of others following suit, directly and considerably. The insurance companies' and swap initiators' models did not adequately account for the system-wide risks that could stem from a string of bankruptcies snowballing into an avalanche of bankruptcies. If you have read my earlier articles on the financial crisis you will see that, though I am now going into more detail on one of the causes, the conclusion is the same: risk was underpriced.

So what can be done about it? Well, there are a few things, but if investors and insurers think investments are safer than they are, crises will always happen, almost regardless of regulation. What are the few things that should be done? Well, regulation. Get rid of CDSs? No. At their core, they are a good idea, and believe me, no one is underpricing risk at the moment. But they do require regulation. Because they were direct deals between two parties (in the derivatives world, direct deals between parties are called over the counter derivatives, President Bush spoke out against those), they were not subject to any regulation whatsoever. This has proved to be a mistake. Certain reserve requirements for insurance companies may be in order, though I stress that they've probably learned that the hard way already (although the important thing is whether they'll remember that lesson in 10 or even 20 years). There is also a second thing that could be done, and this one's a biggie: taking out a CDS on someone else's debt should be outlawed.

One of the staggering things about CDSs is that they were used for speculation, not just for their original (well intentioned and legitimate) purpose of mitigating risk. Speculators would take out CDSs on debts between other companies, basically placing a bet that company A or B would file for bankruptcy. Anyone can see this is an invitation to shady practices when the following rule of insurance is considered: you cannot take out fire insurance on your neighbor's house. It's clear why: that would give you incentive to burn your neighbor's house down, or at least not to call the fire department if it started on fire. This is one area that clearly needs to be within regulation, and it is one purpose for which CDS should be absolutely banned. This fits into my and Mr. Mohr's constant harping about poor incentive structures, basically setting up the system so that people will act foolishly.

So how did this help cause the financial crisis and the recession? That part's easy to see. As real estate prices began to fall, companies that had invested heavily in the real estate markets (read Mr. Mohr's extensive articles on that topic) began defaulting on loans. Soon those CDSs started getting called in, and their issuers (like the insurance company AIG, one of the largest to nearly fall and still only on government life support), not expecting so many to be called at once, also defaulted. Suddenly there was a lot of debt with no one to pay it, and investments that had looked safer than they were because of debt insurance in the form of CDSs were seen as toxic. Loans stopped being made, money stopped flowing, and the whole thing came crashing down. Businesses, even very healthy ones, rely on loans to expand and to do their daily business. The credit crunch made this extremely difficult. The result? Layoffs. This, combined with people being forced from their homes and the loss of equity making everyone feel poorer, resulted in reduced consumer spending, resulting in harder times for companies, resulting in more layoffs and reduced consumer spending. Enter the gut-wrenching downward spiral called a recession we find ourselves in today.

The only hope? Loose monetary policy (which the Fed is on top of, with interest rates around 0%, a historic low), bail-outs to stop or slow the defaults (in progress), and increased government spending (pending). With these three combined and executed well, forecasters hope the recession will end in the seond half of 2009. I'm somewhat less optimistic, considering that even if the recession does end at such an early date (quite questionable considering the optimistic assumptions upon which most forecasters base their predictions), the growth that sets in afterward is likely to be sluggish at best for quite a while, giving the feeling of a continued recession, as real growth (above inflation) of at least 1% is probably necessary for job creation. However, the government endeavors to create jobs itself in the meantime, and with money growing on trees, the government will be able to borrow cheaply and spend through the recession. Even gloomy forecasters see us coming out of the recession by or in 2010, so the end is definitely in sight. By the way, the pessimistic prediction of unemployment possibly reaching 10%, though unprecedented in our time, is still only 2/5ths what it was during the Great Depression. So although it is true that this is the longest and possibly worst recession since the 1930s, is still hasn't (and almost certainly won't) by any means come anywhere near equaling or beating the Great Depression, and that's reason to relax right there.