Credit default swaps were invented by major banks in the mid-1990s as a way to offset risk in their lending or bond portfolios. In a credit default swap, two parties enter a private contract in which the buyer of protection agrees to pay the seller premiums over a set period of time; the seller pays only if a particular credit crisis occurs, like a default. These instruments can be sold, on either end of the contract, by the insurer or the insured. This is captured in the flow chart below.
From a mere $900 billion in 2000, it has ballooned to more than $45.5 trillion in 2007 — roughly twice the size of the entire United States stock market, and dwarfing the US Treasury securities outstanding. And like sub-prime mortgages and CDOs, this market is also unregulated, and populated by hedge funds, private equity firms, and other financial wizards. Commercial banks are among the biggest participants — at the end of the third quarter of 2007, the top 25 banks held credit default swaps, both as insurers and insured, worth $14 trillion, up $2 trillion from the previous quarter. CDS have been iussued on specific corporate debt, indexes representing a basket of debt, on CDOs, and other asset backed securities.
Like with all other instruments the risks remain the same - counter party identification and pricing/valuation. Placing accurate values on these contracts is just one of the uncertainties facing the big banks, insurance companies and hedge funds that create and trade these instruments. Because these trades are unregulated, there is no requirement that all parties to a contract be told when it is sold. As investors who have purchased such swaps try to cash them in, they may have trouble tracking down who is supposed to pay their claims. Further, because these contracts are sold and resold among financial institutions, an original buyer may not know that a new, potentially weaker entity has taken over the obligation to pay a claim.
During the credit market upheaval in August, 14 percent of trades in these contracts were unconfirmed, meaning one of the parties in the resale transaction was unidentified in trade documents and remained unknown 30 days later. In fact, there is no exchange where these insurance contracts trade, and their prices are not reported to the public. Because of this, institutions typically value them based on computer models rather than prices set by the market.
Years of a healthy economy and few corporate defaults led many banks to write more credit insurance, finding it a low-risk way to earn income because failures were few. Speculators have also flooded into the credit insurance market recently because these securities make it easier to bet on the health of a company than using corporate bonds. Both factors have resulted in a market of credit swaps that now far exceeds the face value of corporate bonds underlying it.
But many speculators, particularly hedge funds, have flocked to these instruments to bet on a company failure easily. Before the insurance was developed, such a bet would require selling short a corporation’s bond and going into the market to borrow it to supply to the buyer.
Morgenson sums up the uncertainty thus, "It would be as if homeowners, facing losses after a hurricane, could not identify the insurance companies to pay on their claims. Or, if they could, they discovered that their insurer had transferred the policy to another company that could not cover the claim."
More on the $30 trillion market CDS and regulating it by Gretchen Morgenson here. During the bubble, far too much of this insurance was written at way too cheap a cost, leaving the market insolvent now.
Update 2 (22/5/2010)
Floyd Norris examines the debate surrounding why CDS is no different from any insurance. Plain and simple, CDS are insurance - the buyer of the insurance gets paid if the subject of the swap cannot meet its obligations and the seller of the swap gets a continuing payment (like premiums) from the buyer until the insurance expires.
Where CDS differs from conventional insurance is that it does not have an "insurable interest" (which says that you cannot buy insurance on my life, or on my house, unless you have an insurable interest). Many who despise credit-default swaps argue that they can be used to force companies to fail. The swap market is thin, and even a relatively small purchase can drive up prices. That very movement may make lenders nervous, cause liquidity to dry up and bring on unnecessary bankruptcies.
He writes about another possible impact of credit-default swaps, their ability to undermine bankruptcy laws,
"Normally, a creditor wants to keep a company out of bankruptcy if there is a decent chance it can survive. If it does go broke, the creditor wants to maximize the value of the company anyway, so that more will be available to pay creditors. But what happens if a major creditor, who might even control one class of bonds, has a much larger position in credit-default swaps?
Will he not have interests directly at odds with those of other creditors, since he will do better if the company ends up with less to pay its creditors? Might that creditor seek to, and perhaps be able to, sabotage the company’s best hopes for revival?"