What is a Credit Default Swap (CDS)?
A credit default swap (CDS) is a type of credit derivative that provides the buyer with protection against default and other risks. The buyer of a CDS makes periodic payments to the seller until the credit maturity date. In the agreement, the seller commits that, if the debt issuer defaults, the seller will pay the buyer all premiums and interests that would’ve been paid up to the date of maturity. Through a credit swap, a buyer can take risk control measures by shifting the risk to an insurance company in exchange for periodic payments. Just like an insurance policy, a CDS allows purchasers to buy protection against an unlikely event that may affect the investment.
Credit default swaps came into existence in 1994 when they were invented by Blythe Masters from JP Morgan. They became popular in the early 2000s, and by 2007, the outstanding credit default swaps value stood at $62.2 trillion. During the financial crisis of 2008, the value of CDS was hit hard, and it dropped to $26.3 trillion by 2010 and $25.5 trillion in 2012. There was no legal framework to regulate swaps, and the lack of transparency in the market became a concern among regulators.
Uses of Credit Default Swap (CDS)
Investors can buy credit default swaps for the following reasons:
An investor can buy an entity’s credit default swap believing that it is too low or too high and attempt to make profits from it by entering into a trade. Also, an investor can buy credit default swap protection to speculate that the company is likely to default since an increase in CDS spread reflects a decline in creditworthiness and vice-versa. A CDS buyer might also sell his protection if he thinks that the seller’s creditworthiness might improve. The seller is viewed as being long to the CDS and the credit while the investor who bought the protection is perceived as being short on the CDS and the credit. Most investors argue that a CDS helps in determining the creditworthiness of an entity.
Arbitrage is the practice of buying a security from one market and simultaneously selling it in another market at a relatively higher price, therefore benefiting from a temporary difference in stock prices. It relies on the fact that a firm’s stock price and credit default swaps spread should portray a negative correlation. If the company’s outlook improves, then the share price should increase and the CDS spread should tighten. However, if the company’s outlook fails to improve, the CDS spread should widen and the stock price should decline. For example, when a company experiences an adverse event and its share price drops, an investor would expect an increase in CDS spread relative to the share price drop. Arbitrage could occur when the investor exploits the slowness of the market to make a profit.
Hedging is an investment aimed at reducing the risk of adverse price movements. Banks may hedge against the risk that a loanee may default by entering into a CDS contract as the buyer of protection. If the borrower defaults, the proceeds from the contract balance off with the defaulted debt. In the absence of a CDS, a bank may sell the loan to another bank or finance institution. The effect of this option is the damaging of the bank-borrower relationship since it shows the bank has no trust in the borrower. Buying a credit default swap allows the bank to manage the risk of default while keeping the loan as part of its portfolio.
A bank may also take advantage of hedging as a way of managing concentration risk. Concentration risk occurs when a single borrower represents a sizeable percentage of a bank’s borrowers. If that one borrower defaults, then this will be a huge loss to the bank. The bank can manage this risk by buying a CDS. Entering into a CDS contract allows the bank to achieve its diversity objectives without damaging its relationship with the borrower since the latter is not a party to the CDS contract. Although CDS hedging is most prevalent among banks, other institutions like pension funds, insurance companies and holders of corporate bonds can purchase CDS for similar purposes.
Risks of Credit Default Swap
One of the risks of a credit default swap is that the buyer may default on the contract, thereby denying the seller the expected revenue. The seller transfers the CDS to another party as a form of protection against risk, but it may lead to default. Where the original buyer drops out of the agreement, the seller may be forced to sell a new CDS to a third party to recoup the initial investment. However, the new CDS may sell at a lower price than the original CDS, leading to a loss.
The seller of a credit default swap also faces a jump-to-jump risk. The seller may be collecting monthly premiums from the new buyer with the hope that the original buyer will pay as agreed. However, a default on the part of the buyer creates an immediate obligation on the seller to pay the millions or billions owed to protection buyers.
The 2008 Financial Crisis
Before the financial crisis of 2008, there was more money invested in credit default swaps than in other pools. The value of credit default swaps stood at $45 trillion compared to $22 trillion invested in the stock market, $7.1 trillion in mortgages and $4.4 trillion in U.S. Treasury. In mid-2010, the value of outstanding CDS was $26.3 trillion. Many investment banks were involved, but the biggest casualty was Lehman Brothers investment bank which owed $600 billion in debt, out of which $400 billion was covered by CDS. The bank’s insurer, American Insurance Group, lacked sufficient funds to clear the debt, and the Federal Reserve of the United States needed to intervene to bail it out.
Companies that traded in swaps were battered during the financial crisis. Since the market was unregulated, banks used swaps to insure complex financial products. Investors were no longer interested in buying swaps and banks began holding more capital and becoming risk-averse in granting loans. The Dodd-Frank Wall Street Report Act of 2009 was introduced to regulate the credit default swap market. It phased out the riskiest swaps and prohibited banks from using customer deposits to invest in swaps and other derivatives. The act also required the setting up of a clearinghouse to trade and price swaps.
To discover other avenues of investment besides credit default swaps, check out the following resources from CFI.