Credit Default Swaps (CDS) became famous during the 2008 financial crisis. In 2015, thanks to the movie The Big Short, the wider public was able to learn how they can be used. In this post, we analyze what a credit default swap is, why they play a positive role in financial markets, but also why they can pose a threat to financial stability.
- What is a CDS?
- How a Credit Default Swap Works
- Credit Default Swaps reducing Individual Risks
- Credit Default Swaps increasing Systemic Risks
- CDS indicate the Probability of Bankruptcy for a Company or Country
What is a CDS?
Credit Default Swaps are derivative instruments that allow us to bet on the solvency of a company or a country. As with most financial derivatives, they are usually difficult for many people to understand. However, you will see that they are not as complicated as you may think.
At its most basic, credit default swaps work like insurance policies.
If we take out a home insurance policy, we will have to pay an annual premium to an insurance company. If we have the misfortune of suffering an accident, the insurance company should bear the costs.
Similarly, a CDS allows us, as investors, to buy an insurance policy that will take care of our losses if a company or a country is unable to service its debts. Thus, it allows us to hedge credit risk.
How a Credit Default Swap Works
Let us imagine that we are fixed income investors. We invest in corporate bonds of many different companies. This means we lend money to companies in exchange for interest.
In most cases, the biggest risk we take on when investing in corporate bonds is that those companies may be unable to pay us back in the future. Imagine having bought an Amazon bond that will mature in 5 years. If we are afraid that Amazon could go bankrupt at some point in the next 5 years, we have two alternatives.
The first alternative would be to simply sell the bond and buy something else with that money. Perhaps we can buy a US Treasury Bond that is much safer. However, there are several reasons why large investors do not want to be buying and selling assets continuously.
The second alternative is to buy a CDS on Amazon debt. We can contact an investment bank to find out how much we would have to pay to insure our Amazon bond against any default losses.
Let us assume that we contact Goldman Sachs and they tell us that the price of a 5-year Amazon CDS is 100 basis points. 100 basis points means that we have to pay a premium of 1% per annum of the amount we want to insure.
If we own $10 million in Amazon bonds, the annual premium would be $100,000 (1% of $10 million). In exchange for these payments, Goldman Sachs would cover our losses if Amazon goes into bankruptcy in the next 5 years.
If 2 years Amazon declares bankruptcy, there will be a negotiation between the company and its creditors to restructure the debt.
After those negotiations, it might be decided that creditors will lose 60% of their investment. Therefore, after the restructuring, Amazon would no longer owe us $10 million, as the debt would have been reduced to only $4 million. Therefore, we would have lost $6 million in our investment.
This is a situation in which having bought the CDS would be very useful. We would simply contact Goldman Sachs, let them know that Amazon has defaulted, and they would cover our losses of $6 million.
Remember that we had insured $10 million. But because we were able to recover $4 million in the restructuring process, the CDS would only pay $6 million.
As you can see, the decision to insure that debt would have been a good idea. We would have paid $100,000 a year for two years and recovered $6 million from our Amazon bond losses.
Credit Default Swaps reducing Individual Risks
So far you may be thinking that credit default swaps are harmless. After all, a CDS allows us to hedge the risk of bankruptcy of a company or a country. This is certainly a positive thing and serves investors’ needs.
CDSs allow investors to reduce their level of credit risk without having to liquidate their original investments. Just as there are other kinds of financial derivatives that allow us to reduce other types of risk, CDS address the question of credit risk.
Consequently, you may be wondering why they are considered so dangerous by certain market participants. There are several reasons for this, which we will explore in the next section.
Credit Default Swaps increasing Systemic Risks
These are the main reasons why the CDS market can lead to greater systemic risks:
1) Anyone can Buy a Credit Default Swap
The first reason CDSs can be dangerous is that we do not have to lend money to a company or country before we can buy CDS. That would be like buying a home insurance policy on our neighbor’s house.
We would make premium payments and, if there is a fire in the neighbor’s house, the insurance company will compensate us for our neighbor’s losses. In fact, the entire neighborhood could buy that home insurance policy.
As a result, there may exist many more CDS contracts than existing debt. That is not uncommon. If the markets suspect that a company may be in financial trouble, many investors may want to buy CDS to speculate on the bankruptcy risk of that company.
If the company does not default, those investors would have lost the premiums paid, which can often be high for companies struggling to survive. But if the company does default, those investors will make an incredible return.
For this reason, we can find ourselves in a situation in which a company is unable to pay its debts of $500 million and declares bankruptcy. However, there may be $5 billion in CDS contracts.
Consequently, CDS may magnify the consequences of a bankruptcy if enough CDS contracts have been traded prior to that event.
2) Anyone can Sell a Credit Default Swap
The second reason CDS can be dangerous is that anyone can sell that insurance policy. So far, we have discussed a situation in which a speculator bought CDS to make money, or hedge potential losses, in case a company went into bankruptcy. The seller of that CDS would have been an investment bank.
However, as investors, we can also sell CDS. In other words, we can become the insurance company. The process is exactly the same. We would contact an investment bank, find out how much they would pay us to insure debt of a specific company, and sell that CDS.
Imagine that the price of the CDS is 600 basis points. That would mean that the annual premium would be 6% of the insured amount. If we believe that a company will be able to survive, we can sell $10 million of CDS
Thanks to this, we would be able to receive $600,000 every year (6% of $10 million) without having to do anything, other than guarantee any credit losses. If there is a default, we could lose up to $10 million, however.
As you can see, the risks start to increase when anyone can sell CDS. This is especially true considering that there may be a lot more CDS than bonds outstanding.
3) Counterparty Risk
The consequence of everything we have discussed so far is that the counterparty risk can be very high. Counterparty risk is the risk that the entity with which we have a contract will be unable to pay what it owes us.
In the first example we have discussed, the counterparty risk would be the risk that Goldman Sachs would be unable to pay us if Amazon defaults on its debt. And that could perfectly happen, as one can also buy CDS to insure debt issued by Goldman Sachs itself.
Counterparty risk exists for two reasons. First, because the companies that offer such insurance policies know as CDS (in most cases investment banks) are not infallible. They may have sold many more contracts than they would be able to repay.
In fact, that is what happened in 2008 with the American insurance company AIG, which had been selling CDSs without any checks and balances and despite having limited capital. Once companies started to default, AIG itself hat to declare bankruptcy as it was unable to honor all those CDS it had sold.
Second, since CDS contracts may have been sold by uncapitalized financial players, some of them are exposed to significant counterparty risk. Selling CDS is very profitable as long as there are no defaults, as it can generate income without posting any capital. But losses can potentially be very large.
It should be noted that the latest regulations introduced in the financial markets aim at reducing counterparty risk. But no solution is ever perfect.
As you can see, CDS make it possible for an investor to reduce the risk of some of their investments. But because of the structure of the market, systemic risks can pile up easily.
CDS indicate the Probability of Bankruptcy for a Company or Country
Now that you know what CDS contracts are, how they work, what they are used for, and what risks they may pose to our financial system and the global economy, let us talk about something very useful to analyze the state of a company, a country, or the economy in general.
The CDS market make it possible for us to calculate implied default probabilities for companies and countries. Based on the price at which the CDS contracts to insure debt are trading, we can derive what the market thinks is the default probability for that entity.
The exact formula for calculating the probability of default is very complicated and depends on many variables such as the annual premium of the CDS (the so-called spread, or price), the payment frequency of these premiums, on what dates they are paid, interest rates in the general economy, the duration of the CDS contract and what percentage we think would be recovered from the bonds if there really is a bankruptcy.
If you are interested in the exact formula, here is the link to the ISDA website. ISDA is a supranational entity that regulates the derivatives market.
However, there is a very simple formula to approximate the probability of bankruptcy very accurately. To do this we only need to know the CDS price (the spread) and the duration of the contract. Both variables are readily available. The third variable is the percentage that will be recovered if there is a bankruptcy, but for this we can use a generic percentage.
For most companies, a recovery percentage of 40% is used. That means that, if there is a bankruptcy, the losses will be limited to 60% of the money the company owes. Obviously, it is very easy to adjust the formula if we want to use another recovery rate.
Let us look at an example formula:
If Amazon’s 5-year CDS contract trades at 100 basis points, we already have everything we need:
- CDS spread (or price): 100 basis points (1% per annum)
- CDS contract length: 5 years
- Percentage to be recovered in the event of bankruptcy: 40%
- Probability of bankruptcy in the next 5 years:
As you can see, for Amazon, the probability of bankruptcy at some point in the next 5 years is approximately 8.3%. Despite being low, the probability is far from 0.
Such information is important regardless of whether we are considering investing in Amazon bonds or stocks. After all, in the event of bankruptcy, it is normal for shareholders to lose all their money.
The formula shown is very simple to use and can be applied for countries as well. We simply need to look at the price of the CDS (also known as the CDS spread) and the duration of the contract. Normally, shorter CDS contracts have lower prices since the risk of default in the short term is lower than in the long term.
I hope I have explained clearly enough what a Credit Default Swap is. As you have seen, CDS have certain legitimate applications, both for investors and speculators. But the nature of the market, which allows aggressive trades to be taken in a leveraged way, can make financial markets more vulnerable.
In addition, because CDS usually pay off when there is a recession and a wave of bankruptcies, this is when financial institutions and other market participants are at their weakest.
You may never buy or sell CDS contracts. However, I think it is a key concept to understand when making investment decisions and navigating the financial markets.
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And if you would like to learn about another type of swap, check out the following link:
What is an Interest Rate Swap (IRS)