Credit Default Swaps

Credit default swaps (CDS) must have been what famed investor Warren Buffet had in mind when he called derivatives “weapons of mass destruction.” Unregulated, complex, opaque, and larger than the entire gross domestic product of the United States, credit default swaps played a critical role in the financial crisis of 2008-2009. First used as “insurance” against default risk, credit default swaps encouraged reckless speculation in risky collateralized debt obligations (CDOs), and ultimately themselves became the “drug of choice” in Wall Street’s massive speculative binge.

A credit default swap is a type of derivative. It is a contract in which the purchaser makes payments to the seller in exchange for the seller’s promise to meet the obligations of a bond upon the occurrence of a default or “credit event.”

Purchasers and sellers are typically banks, insurance companies, hedge funds and mutual funds.

Many individual investors were unknowingly exposed to credit default swaps by holding bond mutual funds, which held collateralized debt obligations and purchased credit default swaps as default insurance and/or to speculate. Sellers of collateralized debt obligations routinely assured purchasers that these structured debt products were protected by “credit enhancements.” That protection turned out to be illusory.

Credit default swaps are not traded on an exchange. They are traded over-the-counter (OTC). There is no required reporting of transactions to any government agency, and no regulatory oversight.
Consequently, there is a lack of transparency with regard to a multi-trillion dollar market that poses a systemic risk to the economy. This is of great concern to regulators.

To put the enormous size of the credit default swaps market in perspective, the entire U.S. gross domestic product for 2012 was a little over $15 trillion. The amount of credit default swaps outstanding was $62.2 trillion at the end of 2007 and about $25.5 trillion in early 2012.

Unlike true insurance, a purchaser of a credit default swap need not own the bond being insured (i.e., need not have what insurance law calls an “insurable interest” in the thing insured). This allows rampant speculation in credit default swaps by parties who have no interest in hedging against default by an issuer of a bond they own. Indeed, the market value of credit default swaps far exceeds the value of the bonds that they ostensibly insure.

In 2007, hedge funds accounted for 60 percent of the trading of credit default swaps, and many of them used borrowed money to purchase credit default swaps, further exacerbating the risk.

Counterparty risk is a major concern of regulators. The “insurance” provided by credit default swaps is only as good as the seller’s ability to make good on its payout obligations. Unlike insurance companies, however, sellers of credit default swaps are not regulated; there is no backstop if a CDS seller defaults on its payment obligations (other than the U.S. government and taxpayers).

American International Group, the worlds largest insurer, is also the worlds most notorious example of counterparty risk. In the years leading up to the financial crisis, AIG sold far more credit default swaps on CDOs than it could cover. When CDOs imploded, so did AIG. The federal government ended up bailing out AIG for $85 billion.

Compounding counterparty risk is the problem of identifying who the counterparty is. With no public exchange and poor recordkeeping, and credit default swaps being traded over-the-counter, it is often difficult or impossible to identify the counterparty that is responsible for paying out in the event of a default.

On the other hand, the credit default swap market can be useful in providing another way to rate the default risk associated with bonds. In many instances, the CDS market implies a much lower rating than those provided by rating agencies. For example, during a period when Moody’s gave monoline insurers their highest investment grade rating, the CDS market’s implied rating equated to junk bond status.

Despite the problems and risks associated with credit default swaps, Wall Street banks have resisted attempts to regulate the swaps markets. Under the guise of reducing government spending and “onerous” regulatory burdens, the House of Representatives introduced appropriations bills that would gut the necessary funding to carry out the Dodd-Frank financial reform act, including regulating credit default swaps and CDOs.

If you have investment losses or problems involving credit default swaps, call the lawyers at Page Perry for experienced representation at (770) 673-0047 or (877) 673-0047 (toll free).