Understanding Credit Default Swaps

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Credit default swaps (CDS) made headlines recently as the financial crisis of 2008 expanded into virtually every aspect of the global financial markets and economy. But what exactly is a credit default swap?

[VIDEO] Understanding Credit Default Swaps

Credit default swaps are, for all intents and purposes, simply insurance contracts for bond holders. However, to really understand these relatively new financial instruments—after all, they were only created in the late 1990s by folks at JPMorgan Chase—you have to start from the beginning and take a look at how companies and corporations raise capital. Let’s take a look at the following:

– Corporate capital structure—bonds

– Protection for bond holders

– How credit default swaps work

– The credit default swap market

Corporate Capital Structure—Bonds

Companies need money to function and grow, and when they need to raise money, they have two basic choices: 1) they can issue more stocks and sell equity in the company, or 2) they can issue more bonds and encumber the company with more debt. Oftentimes, it is easier for a company to issue more bonds and encumber the company with more debt because they don’t have to worry about diluting the equity of existing shareholders. However, in order to issue debt, companies have to find investors who are willing to buy the debt.

Companies, just like individuals, have credit scores—called credit ratings. Whereas a bank or mortgage company may look at an individual’s FICO score when determining whether to extend a loan to that person and what interest rate to charge, investors look at a company’s credit rating when determining whether to buy bonds from that company and at what price they are willing to pay. Just as more creditworthy individuals are able to qualify for larger loans with lower interest rates, creditworthy companies and corporations are able to sell larger amounts of debt at lower prices because investors are willing to accept a lower risk premium for that debt.

Rating agencies like Moody’s Investor Service, Standard & Poor’s and Fitch Ratings issue credit ratings for large companies and corporations.

Protection for Bond Holders

Most corporate capital structures protect bond holders above all other investors in the company, but there are still risks. The corporate capital structure assigns a pecking order to investors in the case of corporate bankruptcy/default/restructuring. Typically, the pecking order is as follows:

– Bond holders have first rights to all of the company’s assets and are typically paid back first

– Preferred stock holders are next in line

– Stock holders are at the bottom of the heap

While bond holders are usually first in line to receive money when a company goes under, bond holders have no guarantee that they will be made whole. Depending on the value of the assets of the company, a bond holder may still lose money even once all of the assets have been liquidated and disbursed. To hedge against the risks associated with a company defaulting on its debt obligations, bond holders often turn to credit default swaps.

How Credit Default Swaps Work

Bond holders can protect themselves from default by buying credit default swaps (CDS). Credit default swaps are like insurance against a company defaulting on its debt obligations. In essence, when you buy a credit default swap, you are swapping risk with someone else. Think of it as buying fire insurance on your house. When you buy a home, you take on the risk of that home being destroyed by fire. Now, you don’t really want to carry that risk so you end up buying fire insurance and you swap that risk with the insurance company in exchange for an annual fee. It’s a win-win scenario. You get rid of your risk, and the insurance company makes money.

Just to review, there are two sides of the credit default swap transaction. If you buy the credit default swap, you are paying someone to take the risk that you are currently bearing. If you sell the credit default swap, you are taking on the risk from someone else for a fee.

Typically, credit default swap contracts carry an annual fee. Just like you can choose to make annual payments on your life insurance or your homeowners insurance. The amount the credit default swap buyer has to pay is determined when the contract is created and lasts until the contract expires or the company defaults and the credit default swap is exercised. The amount paid is called the spread and is expressed as a percentage of the total amount of coverage. If the credit default swap is covering bonds worth $1,000,000 and the spread is 1%, the annual fee will be $10,000 ($1,000,000 x 0.01 = $10,000).

The Credit Default Swap Market

Credit default swap contracts are not sold on organized exchanges. Credit default swap contracts are sold over-the-counter (OTC). This means that two private parties get together and agree to the terms of the contract. Because credit default swap contracts are sold over-the-counter, there is currently no real regulation of these contracts.

In recent years, the size of the credit default swap market has ballooned. According to the International Swaps and Derivatives Association, the group that tracks the credit default swap market, by the end of 2007, the credit default swap market had expanded to a phenomenal $62,000,000,000,000. (Yes, that is $62 trillion. I wrote out all of the zeros for effect because this is a huge number we’re talking about here.) Now, by the end of the first half of 2008, the ISDA reported that the credit default swap market had contracted, for the first time ever, to $54 trillion. This indicates that investors are starting to close out of or consolidate their credit default swap trades in fear that the credit default swap market may be the next one to crash and that the credit default swap contracts on Fannie Mae, Freddie Mac and Lehman Brothers have already been settled during the financial crisis of 2008.

The Depository Trust & Clearing Corporation (DTCC), the leading provider of automation solutions for the global over-the-counter derivatives market, announced recently that it will be releasing weekly numbers on the outstanding gross and net notional values (“stock” values) of credit default swap contracts it has registered for the top 1,000 underlying single-name reference entities and all indices, as well as certain aggregates of this data on a gross notional basis only.