Is my understanding of the CDS market correct?
September 23, 2008 11:29 AM   Subscribe

Is my understanding of the Credit Default Swap market correct?

I keep hearing that the current financial crisis was caused by bad mortgages, but I also hear alot about Credit Default Swaps... I heard in congressional testimony that the market for these swaps has gone from 115 billion to 62 trillion over the past few years. I wonder if this bailout is more about paying off the CDS.

The idea was hard for me to understand, so I wanted to draw it out to conceptualize it. I've uploaded a picture of my understanding to Can someone validate my understanding? It is a word document so that people can change it if they want...

posted by joecacti to Work & Money (7 answers total)
I can't see your diagram on this computer but here's my simplified version of CDS:

A bank ("purchaser") gives a loan (e.g. a mortgage) to a borrower. To protect itself against any risk of the borrower defaulting on the loan, the bank purchases protection from another party, such as an insurance company ("seller"). Basically the bank makes payments to the insurance company and in the event of the borrower defaulting on the loan, the insurance company would pay the bank the amount of the loan. It is like an insurance policy but not officially considered insurance for many reasons, one being that the purchaser of the "policy" does not need to own the underlying asset.

Here is one chart that may help to visualize it. Here is another.
posted by triggerfinger at 12:50 PM on September 23, 2008

Right, triggerfinger. Then the insurance company bundles up all the insurance polices it sold to the bank(s) and buys an insurance policy against loses on that from some other entity.

And so on and so on and so on.

joecacti: I don't know you well enough to download and open your *.doc.
posted by notyou at 1:00 PM on September 23, 2008

in the event of the borrower defaulting on the loan, the insurance company would pay the bank the amount of the loan.

One point of clarification: if default occurs, the holder of the bond gets paid the difference between face value and market value. (Or the holder is paid the entire face value but, in return, must turn over the bond. Either way, the net gain is identical.) Market value is almost always non-zero, and is frequently substantial.

(I also did not look at the .doc.)
posted by blue mustard at 1:11 PM on September 23, 2008

The other issue -- and this is why the CDS market is so big -- is that many of the buyers of CDS aren't the lenders in triggerfinger's example.

Many CDS buyers want to speculate that a certain company will default on its debt. It may be difficult to do that by "shorting" outstanding bonds (there may not be enough outstanding, or the bondholders may not want to lend them out). Entering into a CDS allows you to do this, and is one of the reasons why the total "notional" outstanding has grown so quickly. Often, a lot of these trades are offsetting, so the net position is much smaller.
posted by techrep at 2:39 PM on September 23, 2008

Looks like I had it pretty much right... Here's a .jpg of my flowchart:
posted by joecacti at 6:37 PM on September 23, 2008

Is there a difference between credit default *swaps* and *insurance*? It seems like there is. It seems incomprehensible that they can generate $60 trillion just off of regular insurance with a different name.

I think there is an added layer where they start swapping back and forth. BankA buys a swap from BankB, and then BankB buys another one from BankA. The risk is techincally off of BankA's books, but only if the original investment doesn't fail.
posted by gjc at 7:54 PM on September 23, 2008

The diagram is pretty good. A few notes:

1. The CDS has periodic payments, not a one-time payment.

2. Entity B is not always a bank. (It can be, but is not necessarily so. A bondholder can be anyone...)

3. If A's credit rating goes down (or up), there is no exchange of cash between B and C. A credit rating decrease is, by itself, not a default. (Although it can sometimes precipitate a series of events that could lead to a default.)

However, if the credit rating goes down, the CDS becomes more valuable to B, since it is still paying the same amount for "insurance" while the market rate went up. (By market rate, I mean, if it wanted to buy a new CDS, the periodic payments would be more than before.) Bonds decrease in value as credit worthiness declines, so if B actually holds A's bonds, this increase in value of the CDS hedges the decrease in value of the bonds.

Of course, one needn't hold the bonds to buy CDS protection. If one has a view as to the direction of a company's credit worthiness, CDSs allow one to trade on that view. And indeed, plenty of traders do this, trying to find profits even when there are no defaults.
posted by blue mustard at 10:21 PM on September 23, 2008

« Older Warm (and Stained) Leatherette   |   What would happen if a state (RI, purely for the... Newer »
This thread is closed to new comments.