Credit default swaps (CDS) may be described as insurance-like contracts designed to hedge against default on loans or bonds, but they are far from ordinary insurance. Created in the early 1990s by JPMorgan Chase & Co., credit default swaps belong in a derivatives class all by themselves. Some call them ticking bombs; others – most notably billionaire investor Warren Buffett – refer to credit default swaps as financial weapons of mass destruction, carrying dangers that are potentially lethal and deadly.
Now matter how you characterize them, most financial experts now agree that credit default swaps are, in large, responsible for the upheaval in the stock and credit markets and the resulting financial crisis happening around the world.
A credit default swap essentially is an obscure and complex derivative instrument that takes the form of a private contract between a buyer and a seller. The buyer (investor) of a credit default swap pays an upfront fee plus annual premiums to a seller, which typically is a bank or hedge fund, to cover potential loss on the investment outlined in the contract.
The underlying caveat to a credit default swap is the counterparty risk involved in the contract. The credit default swaps market – estimated at $62 trillion in 2007 – is unregulated, with swaps sold over the counter. With no regulation, there’s no entity overseeing the trades to ensure a purchaser of a credit default swap has the financial resources to make good on a swaps contract if it is called in.
Think Bear Stearns. American International Group (AIG). Lehman Brothers Holdings. Lehman Brothers was deeply entrenched in the credit default swaps market. When the company filed for bankruptcy on Sept. 15, 2008, sellers of its credit default swaps contracts found themselves on the hook for billions and billions of dollars.
As for AIG, its involvement in credit-default swaps reportedly pushed the financially troubled firm to the brink of bankruptcy in September before the federal government stepped in with a bailout that now totals more than $182 billion.
And then there’s Bear Stearns. It, too, became crushed under the weight credit default swaps. Its fate was finally sealed when JP Morgan – ironically the inventor of the derivative instruments – purchased the 85-year-old investment firm in March 2008 for the fire-sale price of $2 a share. Under pressure from shareholders, the deal was later revised to $10 a share.