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Economics For Beginners: Credit Default Swaps

Updated on December 2, 2013

What Exactly, Is A Credit Default Swap

To put it in its most basic terms, a Credit Default Swap is an insurance policy on a debt. Now banking professionals (and some economists) will respond in outrage if you ever call it an “insurance policy”, but that’s exactly what it is.

Let’s use an example:

Say there are three people: Tom, Dick, and Harry. Dick has a business that he wants to expand, so he decides to raise money by selling a $1,000 Bond to Tom.

A Bond is an agreement to loan a certain amount of money, for a certain amount of time, at a fixed interest rate; basically it’s an I.O.U. that you get paid interest on.

Let's say that, on Jan 1st, Tom buys a $1,000 bond from Dick that will pay 3% interest (known as the coupon), and which will mature Jan 1st of the very next year. This means that Tom will receive $1,030 from Dick in one year ($1,000 for the bond, and $30 in interest).

Tom is nervous however. Tom doesn’t think that Dick’s business is going to work, and that Dick might not be able to pay the money back. So, Tom goes to Harry and makes a deal: Tom agrees to pay Harry $10 a month, every month for 1 year. In exchange, Harry will cover the $1,000 bond if Dick fails to pay it back. This is a Credit Default Swap.

So to recap: Tom is going to pay Harry a little bit of money each month, so he can avoid a bigger financial loss in the event that something goes wrong and Dick can’t pay bond… sound familiar? It should, because it’s exactly what you do every month when you pay your car/home/life/medical insurance. You pay the insurance company a little bit of money (your premium), in order to avoid a greater financial loss in case something goes wrong (car crash, fire, illness, or death).

Now some of you are saying: “What’s the big deal if it’s actually insurance; Jennifer Lopez insured her butt for $27,000,000 (yes, she actually did this) why shouldn’t you be able to insure a debt”? The big deal is, when you take out an insurance policy, the law requires that the company selling the policy actually be able to pay for it; so when Jennifer Lopez insured her rear end, the company is required to actually be able to pay the $27 Million.

The flip side of this is, when you insure something, you have to disclose all of the risks associated with it. It’s why Car Insurance companies check your driving record, and why some Life/Health insurance companies require you to get checked out by a doctor before they issue you a policy.

With Credit Default Swaps, not only is there no requirement for full disclosure, there’s also no requirement on the amount of reserves a company has to have to sell the CDS in the first place. This means that a company can sell “Insurance Policies” that it has no way of actually paying.

Returning to our example:

Let's say that on Jan 1st, a year later, Dick pays the $1000 bond to Tom. Tom gets his money, and he's happy. Tom paid Harry $10 a month for 12 months, so now Harry has $120 and it didn't cost him anything, so he's happy too. Everything is fine, and everybody wins.

Now let’s imagine that Dick failed to repay the bond. Now Harry has to cover the Credit Default Swap, so he has to pay Tom the $1,000. Tom gets his money back and he's happy, but Harry gambled and lost. Now he's out $880 ($1000 - the $120 he made from selling the CDS). It’s bad for Harry, but not tragic; after all, investments come with risk.

Source: George Rex, CC: BY, via Flickr
Source: George Rex, CC: BY, via Flickr

How Things Went Wrong

The other major difference between Credit Default Swaps and Insurance Policies, and the thing that made them so destructive, is the issue of Insurable Interest.

Insurable Interest basically means that, to insure something, you need to have a direct interest in it. You can insure your home because it’s your home; you have a direct interest in its survival. However, you couldn’t go out and insure a stranger’s home, since its loss wouldn’t affect you directly. This is one of the fundamental aspects of insurance, and it’s the only way insurance companies can do business.

With Credit Default Swaps however, there doesn’t need to be an insurable interest; you can buy a CDS on pretty much any debt, whether you’re involved in the transaction or not.

To continue with our example:

Tom buys both the $1,000 bond and the CDS from Harry for $120, same as before; only this time, there is an added wrinkle. Harry believes that Dick’s business is going to succeed, and he realizes that he’s going to get $120 for doing absolutely nothing. So Harry goes to three more people, let’s call them Mary, Jane, and Sue. Harry tells them that he’ll sell them a CDS (Credit Default Swap) on the $1,000 bond between Dick and Tom. This means that Harry will now earn $120 from all four of them, so he stands to make $480 dollars for doing absolutely nothing, as long as Dick pays the bond.

So now, as it stands, on one single $1,000 bond, there is now $4,000 in Credit Default Swaps on the market. Now I know you can all see how potentially dangerous it is for Harry, should Dick default and not pay the bond; but wait, it’s about to get much, much worse.

Source: 401(K) 2013, CC: BY-SA, via Flickr
Source: 401(K) 2013, CC: BY-SA, via Flickr

Things Go From Bad To Worse

So far, our example shows how the seeds for the financial crisis were sown, but it still doesn’t explain how it was so massive and so wide spread. Well, that’s where leverage comes in.

Leverage, in this case, is when a person/company borrows money to increase the profitability of a financial transaction. For example:

Let’s say you can buy a widget for $10 and sell it for $15; you’d make a $5 profit ($15 - $10 = $5). Now, say you borrow $100 and buy 10 widgets for $10; you sell them all for $15. This time, you make $50 in profit ($15 x 10 = $150 - $100 = $50), you used leverage to increase the profits on the deal.

Now meet Bill. Bill in an investor, and he heard about the Credit Default Swaps that Harry was selling, and he wants in. Bill decides to leverage the deal by going to the bank and borrowing $12,000 enough to buy 100 Credit Default Swaps. So Bill gets the loan, and he calls Harry and tells him that he wants to buy 100 Credit Default Swaps on Dick’s bond. Harry is happy to sell them, that’s an extra $12,000 in, what Harry believes, is essentially free money.

So now, on one single $1,000 bond, between Tom and Dick, there is now $104,000 in credit default swaps on the market. Harry stands to make $12,480 dollars, for doing absolutely nothing, and he’s as excited as can be… for now.

This is exactly what happened during the financial crisis, companies borrowed huge amounts of money to leverage the purchase of these Credit Default Swaps; which the banks were more than happy to sell them. As you’re about to find out though, there was a big problem; I’m sure some of you have already figured it out.

See what Harry doesn’t know, is that Dick found out about the CDS deal. So he decided to make some money… by calling his brother Bill. The same Bill that Harry just sold those 100 CDS’ to.

Source: david_shankbone, CC: BY, via Flickr
Source: david_shankbone, CC: BY, via Flickr

How It All Falls Apart

So now, Tom is happy because he’s covered for his $1,000 thanks to his CDS. Mary, Jane, and Sue are happy because they stand to make $1,000 if Dick defaults, since they each bought a CDS. Harry is happy, sure he’s on the hook for $104,000 if Dick defaults ($1,000 for each of the 104 CDS’ he sold), but he believes in Dick’s business, so he stands to make over $12,000 dollars.

So, the year goes by and the bond matures; only Dick doesn’t pay. He defaults, which he always intended to do, since Bill is his brother. So now Harry has to pay Tom $1,000 to cover the CDS; he also has to pay Mary, Jane, and Sue $1,000 each to pay for their CDS’. Then Harry has to pay Bill $100,000 to cover the 100 CDS' that he sold him. So now, there has been a total of $104,000 paid out, all on a single bond of only $1,000.

The problem now is, Harry doesn’t have enough money to pay out the $104,000 he owes, so he’s forced to declare bankruptcy. Harry is ruined. He’s lost everything, and now he has no idea how he’ll support his family. So Harry turns to his parents. Harry’s parents decide that having Harry go bankrupt would be devastating; they worry about what would happen to his wife and kids, so they decide to step in and cover his debt. They pay the $104,000 to get Harry off the hook. So everyone gets their money, and life goes on, only now, Harry’s parents are out the $104,000 they paid.

This is, again, is exactly what happened in the Financial Collapse. All you need to do is call Tom, Mary, Jane, and Sue by their actual names: Lehman Brothers and Bear Stearns; Bill is also known as Goldman Sachs, and Harry, well his real name is AIG. Oh, and don’t forget Harry’s parents, you know, Harry’s parents: the ones that stepped in at the end and bailed him out, the only ones in this whole scenario that actually lost money, that was Harry’s Parents… also known as The U.S. Government.

Right now most of you are thinking: “But Shawn, yes this was bad, but we’ve learned our lesson and the laws have been changed so that this kind of thing can never happen again, right”?

It’s happening again right now.

© 2013 Shawn McIntyre

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  • Shawn McIntyre profile image
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    Shawn McIntyre 3 years ago from Orlando, FL.

    @heidithorne Thanks, I'm glad you enjoyed the article =)

    You would think we would have learned from our mistakes, yet here we are again.

  • heidithorne profile image

    Heidi Thorne 3 years ago from Chicago Area

    Oh, Shawn, this is such a sad scenario that gets played out again and again. Ugh! Great way of telling it as a story. Voted up and sharing!

  • Shawn McIntyre profile image
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    Shawn McIntyre 3 years ago from Orlando, FL.

    @one2get2no Thank you, I'm glad you enjoyed the article. =)

  • one2get2no profile image

    Philip Cooper 3 years ago from Olney

    Great article...you made it simple to understand.

  • Shawn McIntyre profile image
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    Shawn McIntyre 3 years ago from Orlando, FL.

    @Mel Carriere Thanks for taking the time to stop by and read my article =)

    I try hard to keep it understandable. I catch myself getting all "economisty" sometimes though, so it's a constant struggle. =)

  • Mel Carriere profile image

    Mel Carriere 3 years ago from San Diego California

    Wow! Extremely informative, educational, and written in a way that you dumbed it down for the laymen without making it too dumb. I can see how the economy could down-spin so rapidly with these types of transactions taking place. Great hub!