What the hell is a credit default swap?

Andrew Pegler – 23 April 2010

They were pivotal in bringing on the GFC and have surfaced as a powerful, mysterious force behind the European default jitters. But does anyone out there actually know what a credit default swap is? Read on for the plain English version.

Credit default swaps (CDSs) were invented in the late 1990s by Wall Street pointy heads. Since 2000, their market has grown from $900 billion to over $30 trillion. And it’s mostly unregulated. Credit default swaps come under the banner of exotic financial instruments (a great name for a Nick Cave backing band?). A financial instrument is something that has monetary value i.e. currency, shares, bonds etc. CDSs are exotic because they’re “pretty out there man”.

In essence, a credit default swap is an insurance policy you take out to reduce the risk of someone not being able to pay a debt. You swap the responsibility of a credit default to an insurer – hence credit default swap. In other words CDSs reduce the risk to a bank of lending someone money. Think of it in terms of Hollywood. If a movie producer takes out an insurance policy on an unreliable movie star it makes it easier for them to raise money for the star’s picture. So if the star is too stoned to film the backers still get their money back.

Here’s an illustrative story starring Wayne, Dean and Bryce. Wayne (the insured i.e. a bank) pays Dean (the insurer i.e. AIG) to insure him against the risk that Bryce (some bloke) won’t be able to pay his mortgage. Wayne just bought a CDS off Dean. One Friday night Bryce loses real bad on race 6 at the Dapto Dogs so Dean (the insurer i.e. AIG) now has to pay Wayne the money Bryce owes because he said he would because Wayne swapped the default to Dean.

Anyone else noticing this central idea of swapping the responsibility of a credit default away from you and onto the insurer?

Anyway with the GFC the problem was that Dean (the insurer i.e. AIG) was supposed to put aside a certain amount of money in case he had to pay Wayne (the bank). But it was unregulated and in the insane credit environment leading up to the credit crisis, the amount Dean put aside was too small to pay anyone. Hence utter chaos and financial Armageddon as sub-prime mortgages across America began to fall like dominoes taking the US economy with it. And the root of all this was the CDS.

I hope that clears that up your honour!

In other news… while on the subject of credit, credit reporter Dun and Bradstreet has revealed that it has downgraded the rating of 16 countries since the start of this year. However, Australia has been upgraded and is now one of the safest countries in the world to invest. The lucky country trundles on eh?