Key takeaways
- Credit default swaps are a financial derivative that large investors may use to insure their bond investments against default.
- CDS were right at the center of the 2007-2008 financial crisis, as many investors bought them to profit on the decline in debt securities.
Credit default swaps (CDS) are a type of financial derivative that provides insurance against the risk of a company defaulting on a debt. A CDS is like an insurance contract between two parties, in which one party agrees to pay the other in the event of a borrower’s default on a loan or other debt obligation.
Here’s how credit default swaps work, their role in the Great Recession and answers to frequently asked questions about CDS.
What are credit default swaps and how do they work?
Credit default swaps insure a loan or bond in case of default. They allow the CDS buyer to transfer the credit risk of the underlying asset to another party for a relatively small fee. Buyers make periodic payments to the seller, typically quarterly or monthly until the contract’s maturity (end) date or until a credit event is triggered. In a way, a CDS operates like an insurance policy.
If there is a “credit event” in the underlying asset, such as a bankruptcy, that triggers the CDS, the seller of the CDS pays the buyer the contractual amount.
What are credit default swaps used for?
Credit default swaps are widely used for hedging risk and speculation. For example, if a bank has a large real estate loan, it can buy a CDS to protect against the risk of default losses. Investors can also use CDS to speculate on the creditworthiness of a company or country.
Although CDS are usually traded over the counter (OTC), they are not as regulated as exchange-traded products. Before the 2007-2008 financial crisis, they were even less regulated.
Example of a credit swap
Investor A owns $100 million of debt issued by Shaky Borrower B because it pays 8 percent. Now it wants to offload the risk that B can’t make good on its bonds. So it decides to buy a CDS on these bonds, and Insurance Company C says that it’s willing to sell one.
The investor and insurance company agree that the investor will pay 1 percent of the bond’s face value each year to insure the bond. The investor pays $1 million each year ($100 million * 1 percent) for the life of the bond. In exchange, the insurance company says that it will pay the investor the value of its investment if Borrower B is unable to pay its debt.
The insurance company collects $1 million each year, while the investor pays $1 million of the $8 million income it receives from its investment, while still earning $7 million on the bonds. As long as the borrower pays the interest on its debt or meets the other conditions of the CDS, such as not going bankrupt, then the insurance company will not need to do anything.
If the borrower experiences a credit event that triggers the CDS, then the insurance company owes to the investor the full value of its $100 million investment.
Pros and cons of credit swaps
Pros
- Protection for bondholders: Those who have invested a significant sum in bonds may use CDS to gain protection for their investment at a reasonable cost. A CDS allows them to invest in bonds and offload some of the risk to those who are willing to accept it.
- Risk diversification: A CDS allows those who want to buy and sell the risk of an issuer defaulting on its bonds to do so. Via CDS, risk can be spread and diversified across the financial system, letting financial players trade it to those who are willing to take the risk.
- Keeps market orderly: CDS help provide important informational signals to the market about the creditworthiness of a bond’s issuers, helping investors and others understand how the company is viewed in the market.
Cons
- Highly leveraged transactions: A CDS is highly leveraged by its very nature, much like an insurance contract. So if a bond goes into default, the insurer must pay out many times the value of the “premium” payments received.
- Counterparty risk: Any buyer of a CDS needs to know that the seller is able to meet its obligations under the terms of the contract. The seller must have the financial wherewithal to meet the terms of the contract, but because a CDS is a highly leveraged instrument, the CDS seller may not be able to settle the contract, especially if it has to make good on several CDS at one time, perhaps during a financial crisis.
- Speculative activity: CDS can encourage speculative activity, which may not be especially valuable. Like other derivatives such as futures, investors and companies have a legitimate use for CDS but they may also be used for pure speculation.
How do credit default swaps trigger?
In a CDS contract, typically the buyer and seller agree upon a number of credit events that would initiate the CDS buyer settling the contract. These could include the following:
- Failure to pay the bond
- Bond restructuring
- Bankruptcy
A full list of credit events should be listed in the contract. Settling the contract generally means the sellers will receive cash or a bond from the buyer.
Is trading in credit default swaps legal?
Yes, it’s legal. CDS fall under Securities and Exchange Commission (SEC) and Commodity Futures Trading Commission (CFTC) regulations that cover the parties involved and their activities. The passing of the Dodd-Frank Act in 2010 introduced stricter regulations on CDS and imposed stringent record-keeping and reporting requirements on buyers and sellers to help prevent adverse effects on the market.
However, some analysts argue that “engineered” credit default swaps, which is when an investor collaborates with financially distressed borrowers to guarantee the profitability of their CDS position, should be more regulated. Currently, they fall under a legal gray area. According to a New York University Law Review paper from 2019, engineered CDS can “inflict negative externalities upon third parties, including diminishing pricing efficiency, impairing market integrity, and imposing costs on non-CDS investors.”
The role of CDS in the 2007-2008 financial crisis
In the lead up to the financial crisis, investment banks created mortgage-backed securities, credit default swaps and collateralized debt obligations (CDOs), and placed bets on the performance of these derivatives. Prior to the credit crisis, credit default swaps were very popular, with an outstanding value in excess of $45 trillion. When the housing market blew up and took mortgage-backed securities with it, many financial institutions suddenly found themselves owing huge amounts of money to investors who had bought CDS, leading to many insolvent organizations.
At the center of things was the CDS, which exposed financial institutions to the potential for a highly leveraged trade that worked against them, and many counterparties were unable to pay up. So what looked like easy money — insuring a bond against default — was anything but. The insolvency of banks trading in CDS caused significant fluctuations, and bond insurance companies had to raise capital in the event of possible defaults. The Dodd-Frank Act now gives regulatory authority over the swaps market for securities to the SEC and CFTC. The act requires parties to record and report all CDS transactions, helping to reduce counterparty risk.
Bottom line
Credit default swaps are designed to provide protection against fixed-income products. They are legally traded in the U.S. and regulated by the SEC and CFTC. Although they can offer investors protection against default, they also come with high levels of risk and should be used with caution.
— Bankrate’s James Royal, Ph.D., contributed to an update of this article.
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