What is a CDS?

I read a lot about Credit Default Swaps, and I remember being puzzled by them at first.  The concept of a CDS is somewhat confusing, but the way the banks have been using them muddles the issue further.  I’d like to try to clear some of this financial fog up.

Let’s start with a couple of terms:

• Counterparty – if party A enters into a contract with party B, party B is the counterparty from party A’s perspective.  (From party B’s perspective, the counterparty is party A)
• Premium - this is a dollar amount that is paid for a service (usually related to insurance — I pay a premium every 6 months for my car insurance)
• Default Risk – this is the chance of a company going bankrupt.  Note that bankruptcy doesn’t necessarily mean the company is closing down, it just means that a court has assigned the status of “bankrupt” to the company, which allows the company some legal protection against anyone it owes money to.
• Default Event – this is a specific point in time when a default occurs.  If a company enters bankruptcy, we say that a default event has occurred.
• Swap value – this is an amount of money agreed upon in the CDS contract.  It will be paid out if the specific default event occurs.
• Debt level - this is the amount that a company owes in debt to various lenders.
• Leverage - this is the ability to use money that you don’t necessarily have to make bigger returns on the money you do have.  (think about borrowing money to buy a house — if the house appreciates by 1%, that is 1% of the house value, not the amount that you actually have — and the house value is probably much higher than what you have)

Now that we have these terms, let’s describe a CDS:  CDS is a contract between two parties, let’s call them Party A and Party B.  Party A pays a periodic premium to Party B.  Party B guarantees that if a certain default event occurs, Party B will pay Party A the swap value (for example, the swap value can be the same as the debt level of Party A).

You can think of CDS as insurance against bankruptcy.  If you are worried you might go bankrupt, you can find a counterparty who is willing to write a CDS on your bankruptcy, let’s say for your current debt level.  You would then pay a periodic (monthly for example) premium, and in exchange you would be paid a swap value if you went bankrupt.

Why does a CDS exist, then, if it is essentially just bankruptcy insurance?  This is where the banks got clever –  insurance is heavily regulated by various government agencies, so you have to meet all kinds of requirements to be able to sell insurance.  CDS is not regulated by anyone anywhere, so it’s the wild west of insurance.

What does a lack of regulation provide?

The first thing that this lack of regulation provides is the ability to place bets on OTHER companies (this is often called a “naked” CDS).  Let’s go back to Party A and Party B.  In our example, Party A is buying a CDS from Party B for a Party A default event.  But why stop there?  What if Party A likes to follow Party C in the news, and wants to bet that Party C will go bankrupt?  Party A can buy a Party C default event CDS — without having to have any relationship with Party C at all!

The second thing provided is the ability to place multiple bets on a debt.  Suppose Party C has a $10 million debt level.  Party B might offer a CDS that pays $10 million if Party C goes bankrupt.  So far so good, the $10 million debt level is covered.  But there is no rule saying that Party B can only sell up to $10 million in CDS!  Party A can buy that CDS, Party D can buy it, Party E can buy 4 of it, etc.  Now, if Party C DOES go bankrupt, Party B will owe MUCH more than the actual debt amount to many more counterparties.  On the other hand, if Party C DOESN’T go bankrupt, Party B collects TONS of premium!  Seems kind of like a scam?  I think so, too.

A third, less obvious thing that unregulated CDS provides is leverage.  In the above example, Party B can create some pretty extreme leverage for itself by selling more than the debt level of Party C.  Particularly if Party C never actually does go bankrupt, Party B has created a lot of money for itself from nothing at all.

The fourth thing that this creates is interconnectedness.   Now if Party C goes bankrupt, Party B feels it, too, and possibly a lot worse than Party C.  If we were talking about lots of different CDS contracts, written and bought by all the big banks, you can see how this could create all kinds of connected problems.  What if C’s bankruptcy caused B to go bankrupt, too?  What if A had a CDS on B written by C?  How does that resolve?  What a mess!

Lots of people are thinking about lots of solutions to this problem.  One obvious solution is to disallow naked CDS, and/or to disallow CDS swap value in excess of the debt level it is trying to protect.  Another solution is to regulate CDS like we regulate insurance.  Still another solution would be to tax a CDS, which forces all involved parties to think a bit harder about whether to enter the contract.

So far, very little has changed with regard to CDS regulation, and the big banks have every incentive to keep doing them, since the government has bailed out failed CDS contracts.  The lobbying power for these institutions must be enormous to prevent such obvious checks and balances on an insane risk system.