Credit Default Swaps: What These Complex Instruments Do and Why They Still Matter Today
by A. Horrigan
20 Sept 2017
Leading up to the financial crisis of 2008, insurance companies, hedge funds and other institutions that traded in credit default swaps (CDS) operated in a black box. Regulators, lawmakers, journalists, and most citizens didn’t understand what these strange-sounding investment instruments were.
After the crisis, journalists like Matt Taibbi walked us through the enigmatic CDS “derivatives” and how they contributed to the collapse. In Rolling Stone magazine and his book Griftopia, Taibbi described a CDS as an arcane financial instrument that pretended to “scrub housing debt” of risk—making doomed mortgages seem like great investments.
An Insurance Contract Derived from Debt
A CDS is a type of investment instrument, or "derivative," that provides insurance against non-payment of a bond or debt. If a homeowner stops paying on a mortgage debt, a CDS ensures the mortgage bank still gets paid. For this insurance, the bank pays a small bit of the interest it earns each month to the issuer of the CDS.
Fortune writer Stephen Gandel notes that CDS “are contracts that allow investors and traders to bet on whether a company, a country or a group of companies, countries or individuals will pay back their loans.”
Blyth Masters is often described as the architect of CDS derivatives.
Financial advisor Andrew Millard created a great video demonstration of how CDS derivatives work, using a doll, toy barn and some poker chips. In 2008, financial firms were unable to pay up on trillions of dollars’ worth of CDS arrangements. American taxpayers had to bail out the financial firms and banks, people lost their jobs and homes, and homeowners got blamed. “This is a problem that still has not been fixed,” said Millard.
They Get Stranger
CDS contracts can get very complex. Goldman Sachs, Deutsche Bank and others pooled thousands of mortgages into mortgage bonds (“mortgage-backed securities), sliced those into sections of riskiest mortgages and turned hundreds of those sections into yet more derivative instruments—collateralized debt obligations (CDOs). Dan Wang explains how financial institutions then illegally profited from the failure of those CDOs.
A CDS gets a rating, and this is supposed to protect investors. But the big three rating agencies—Moody's Investors Service, Standard & Poor's, and Fitch Ratings—gave higher ratings to trillions of dollars’ worth of loans than they deserved. Many of those loans were made to people with no proof of sufficient income and unsound credit standing. The loans were very likely to be defaulted on.
As a result, Bear Stearns, Lehman Brothers, and Merrill Lynch had to dissolve, and U.S. taxpayers had to buy $700 billion in bad debt from other financial institutions to keep them from falling apart—because their falling apart would have resulted in further financial ruin for everyone. Mortgage holders didn’t get bailed out, though—they lost their homes, jobs and pensions.
Regulation Steps In
“In the years leading up to the 2008 recession, the buying and selling of credit default swaps was not watched by regulators at all,” wrote Megan Guess in Ars Technica, quoting NPR: “If bad mortgages got the financial system sick, credit default swaps helped spread the illness worldwide.”
In response, the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 began to require financial institutions to clear credit default swaps through a central exchange, to be overseen by the Commodity Futures Trading Commission (CFTC). This is just one thing the Act does to protect against catastrophic economic failure.
Under Dodd-Frank, “U.S. banks have more substantial loss-absorbing capital cushions, increasingly rely on stable sources of funding, undergo rigorous stress testing, and plan for their orderly failure,” notes the Center for American Progress.
Where are we now?
Fast forward to today, and CDS derivatives are still with us, because the people who struck it rich from them are still running the banks. “By 2007, the managing directors and desk heads at most major investment banks had built their careers off the back of CDS mania,” according to Business Insider. And “CDS-focused leadership at many major investment banks has remained in place.”
The Center for American Progress says President Trump’s Financial Choice Act would dismantle Dodd-Frank: “The desire to roll back these reforms demonstrates a willful ignorance of those very lessons at best and a malicious disregard at worst,” it reports.
The use of CDS instruments continues to increase, and big banks now plan to put CDS contracts on permissioned ledgers (see related article, Big Banks Plan to Settle Credit Default Swaps on a Blockchain Next Year: Are Regulators Watching?).
Banks have grown bigger and stronger. In 2014 Taibbi noted how “the banking sector that came so close to ruining the world economy five years ago has now vastly expanded its footprint. ” He wonders, “who's in charge of preventing the next crash?” He answers his own question: “In this Brave New World, nobody knows.”
Perhaps the rise of bitcoin, blockchain and innovative fintech companies with new business models may diminish the increasing power of financial institutions, but it doesn’t seem the CDS is going to disappear.
Additional Resources:
Credit Default Swaps: Dubious Instruments -- Harvard Business Law Review
Why it’s time to outlaw credit default swaps – Fortune
How Credit Default Swaps Became a Timebomb – Newsweek
JPMorgan Discloses $2 Billion in Trading Losses– New York Times
2008 crisis still hangs over credit-rating firms – USA Today