This the third article in a series about the causes of our current financial crisis.

In the first two articles of this series “The Financial Crisis – It’s Not That Complicated”  I covered Sub-prime Mortgages and Collateralized Debt Obligations.  We saw how a 330 billion-dollar Subprime Mortgage problem turned into a much bigger problem with CDOs, (Collateralized Debt Obligations.) In this article we’ll delve into the murky world of Credit Default Swaps. They take the problems to a whole new level.

Credit Default Swaps, CDSs for short, are a type of financial derivative.  A derivative, in the financial world, is a financial instrument that derives its value from an underlying asset.  Since CDSs deal with credit as an underlying asset, a CDS is a “credit derivative.”

In concept, Credit Default Swaps are pretty simple.  They are very much like an insurance policy.  You pay the issuer a periodic premium and if something bad happens to the underlying asset you get compensated.

Let’s say you invest in a 5-year, $10 million bond from Ford Motor Company and shortly afterward you hear some bad news about Ford’s financial situation. After a week or so you start to question whether or not Ford Motor Company will make good on its promise to pay you back with a profit.  You could buy a Credit Default Swap that will cover your losses if Ford fails to repay your principal plus interest at maturity. This is one way you can “hedge” your investment.

CDSs are normally between two parties, a Seller and a Buyer. Each is called a “counterparty.”  The Seller sells protection to the Buyer.  The Buyer pays the Seller a yearly premium, usually expressed in “basis points.”  A basis point is one-hundredth of 1%,  (.001% ) of the amount being insured.  Most CDSs are written for a period of five years. In addition to the yearly premium, some CDS contracts require an additional payment at the beginning of the contract.  This is an “upfront” payment usually expressed as a percentage of the face value. The amount being insured, the face value, is called the “notional” amount of the CDS.  A CDS priced at 50 basis points that covers a $10 million bond would cost $50,000 per year.  
 

An important element of the Credit Default Swap is called a “triggering event.”  Both parties must agree on what will trigger default and thus payment to the Buyer.  The trigger can be any one of a multitude of possible events and usually it takes just one event to trigger the default.  It may include bankruptcy of the issuer, a downgrade in the issuer’s credit standing, a downgrade of the bond rating, or even a change in executive leadership in the issuing company.

Normally the CDS works like a term life insurance policy. If the CDS triggers, payment is made to the buyer of the CDS. If nothing bad happens within the term of the CDS then the contract is over and the Buyer gets no payment. There can also be provisions in the CDS contract that require the Seller to prove that they CAN pay if the CDS triggers.  Many of AIG’s CDSs required them to post additional collateral if their, (AIG’s,) credit rating went down.  It did, and that’s where much of the bailout money went when AIG was rescued by the taxpayers. This money normally goes back to the Seller if the CDS does not trigger.

Let’s assume your Ford Motor Company 5-year, $10 million bond has its rating lowered from AAA to A+. The CDS you bought states that anything below AAA constitutes a triggering event. Your CDS triggers. You are then required to deliver the underlying asset (the Ford bond) to the Seller of the CDS. The CDS Seller then gives you, the CDS Buyer, the face value of the CDS contract. The Seller of the CDS owns the bond and can sell it to help make up for their loss on your CDS payout.

Since CDSs are like insurance policies you would think that the total notional (face value) of all of the CDSs in existence would not exceed all of the debt to be insured. But, as of April 22, 2009, there were approximately $38.6 trillion in outstanding CDS contracts.

The total corporate debt in the US at the end of 2008 was estimated to be $7.1 trillion. If there were credit default swaps on all of it, the face value should not be more than that amount. So why is there so much more in Credit Default Swaps? One simple reason; Credit Default Swaps can be purchased by anyone! You don’t have to own the underlying security to buy a CDS. It’s legal and it happens every day in the world of finance.

Imagine what the world would be like if anyone could buy a fire insurance policy on your house. Without your permission and without your knowledge! The person that bought the insurance on your home is not interested in your well-being.  The only way they can make money on the deal is if your house burns down. Fortunately our laws don’t allow strangers to buy fire insurance on our homes.

When a credit event triggers a CDS and the CDS Buyer doesn’t own the underlying asset, the Seller of the CDS compensates the Buyer the difference between what the underlying asset is worth and the face value of the CDS contract. This amount is determined by an auction of the Seller’s interest in the CDS that has defaulted. If the auction produces 25% of the face value of the CDS, then the Seller has to pay the Buyer 75% of the face value, (100% minus 25% equals 75%.)

Although CDSs were originally used as a hedge for bond investors, they are now written to cover just about anything having to do with credit. There are CDS contracts on the credit worthiness of large corporations, mortgage-backed securities, 10-year US Treasury notes, and even entire countries. Just Google up any corporation, security, bond or country followed by “CDS” and you’ll likely find someone willing to sell you a Credit Default Swap contract on it.

A CDS that is purchased by someone not owning the underlying asset is known as “Naked” Credit Default Swap. It this form many people feel it is more like a bet than an investment. Holders of naked CDSs only win if something bad happens. And some have been involved in making things worse by helping to force an underlying company into bankruptcy.

But, like I said, it’s OK on Wall Street. And that’s one of the big problems we have in unwinding the mess that the financial experts have put us in. They have created a 38.6 trillion-dollar time bomb. It is a problem created by Wall Street but the affect is global.

Another very big problem with CDSs is the fact that they are unregulated with no government oversight and no transparency. They are a big part of the reason that the credit markets are locked up. Banks don’t know what the other banks are doing with CDSs.  They don’t know if the other banks have a lot of exposure to CDS claims or not. Since no information is made public they don’t know who the counterparties are  and if they could pay off CDS’s held by the other banks. They can’t measure the risk of loaning money to them. And when they can’t measure the risk, they are not going to take a chance.

And that’s why the Feds are trying to fix the sub-prime mortgages. The sub-prime problem lit the fuse that blew up the mortgage-backed securities that in turn exposed the CDO debacle. The effort you see from Washington is an attempt to extinguish that fuse. I hope they succeed.

Investments in CDOs were made by banks, pension funds and individuals. They sit in thousands of 401ks. If the CDO problem isn’t fixed it has the potential to trigger thousands of CDSs. If that happens, it could unleash a financial disaster that will make what we’ve seen so far seem like a pleasant walk in the park.

In the next article we’ll look at how Wall Street convinced themselves that Credit Default Swaps were a good thing, what the US Government did to encourage them, and how they will profit from the clean-up efforts of the current administration.

COPYRIGHT 2009 BY RAY WOOD