Perhaps a question that some executives, politicians, investors and all taxpayers should have asked significantly sooner, is what is a credit default swap? In it’s simplest form, a credit default swap (hereinafter CDS) is a contract in which one party (the buyer) makes a series of small payments to another party (the seller). In return for the small payments, the buyer receives a lump sum if the instrument goes into default. Generally, CDSs are done with a bond or a loan as a credit instrument, and it is not necessary for the buyer to actually own the underlying bond or loan.[i]
Some have defined a CDS as being a credit derivative contract between two parties. [ii][iii] A credit derivative then, is defined as an instrument where the value is derived from the amount of risk on the underlying loan or bond. The reason that credit derivatives are popular is because the risk is shifted to an entity that is separate from the transaction. The third party or other entity is referred to as the reference entity and can be any institution or organization that has incurred some form of debt.[iv][v]The two parties to the contracts (buyer and seller) are agreeing to a form of protection against a risk associated with the reference entity. These risks can include: 1) bankruptcy; 2) payment default; 3) obligation default; 4) restructuring; and 5) where an obligation will be accelerated.[vi]
There are two major kinds of credit derivatives-unfunded credit derivatives and funded credit derivatives. An unfunded credit derivative can be defined as a contract between two parties in which each party has a responsibility to make payments without resorting to a use of other assets.[vii] A funded credit derivative, on the other hand, is where the party that is assuming the risk makes initial payments that are used to “settle” any potential events (such as default).[viii]
A CDS then, as mentioned previously, is a form of credit derivative. More specifically, it is a form of an unfunded credited derivative product. Some have likened a CDS to a form of insurance, and while there are some similarities between the two, there are also some significant differences. For example, the seller does not need to be a regulated entity; the seller is not required to maintain any reserves to pay off the buyers; and the buyer of a CDS does not necessarily have to own the underlying security[ix]. Another significant difference is the nature of how the parties manage the risk. Insurance companies or agents manage risk by setting “loss reserves” (the amount of money in the pool to pay off buyers upon the happening of a stated event) based on the Law of Large Numbers (hereinafter LLN)[x] whereas those who deal in CDS manage their risk in large part by hedging with other dealers in the bond market.
While a large majority of the public still believes that CDSs are a new phenomenon, they were actually invented by team working for JPMorgan Chase in 1997.[xi][xii] The CDS was created in large part to raise more capital, and were designed to shift the risk of obligation or payment default to a third party.[xiii] As mentioned previously, CDSs became largely freed from pervasive regulation by both the SEC and the Commodities Future Trading Commission (hereinafter CFTC) with the Commodity Futures Modernization Act of 2000 (an act also credited with the Enron loophole), when legislation was passed that ruled that credit default swaps were neither gaming nor a security and were therefore not subject to those constraints.
In summation, if a CDS is not gambling, and is also not a security, it is not regulated as such.
[i] “In a credit swap, two parties agree to exchange cash flows based on the cash flows of a reference asset (e.g., the bonds of a risky borrower) and a reference rate (e.g., a comparable government security), or on the occurrence of a particular credit event.” Partnoy, Frank “The Siskel and Ebert of Financial Markets?: Two Thumbs Down for the Credit Rating Agencies” Washington University Law Quarterly Fall 1999. 77 Wash. U.L.Q.619, 677.
[ii] CFA Institute. (2008). Derivatives and Alternative Investments. Page G-11. Boston: Pearson Custom Publishing.
[iii] “More specifically, a credit default swap is a bilateral financial contract in which one counterparty (the protection buyer) pays a periodic fee, typically expressed in fixed basis points as a percentage of the notional amount, in return for a floating payment contingent on the default of one or more third-party reference credits. This floating payment is designed to mirror the loss incurred by creditors of the reference credit in the event of default, and usually is calculated as the fall in price of a reference security below par at some pre-designated point in time after the reference credit has defaulted.” Partnoy, 1999, at 677.
[iv] Das, Satyajit (2005). Credit Derivatives: CDOs and Structured Credit Products, 3rd Edition. Wiley.
[vi] This is not an exhaustive list. There are other types of “events” that the parties to the contact can agree to include in the transaction.
[vii] Dominic O’Kane. “Credit Derivatives Explained”. Lehman Brothers, posted on Simon Fraser University website at http://www.sfu.ca/~sp6048/Reading/LEH%20O’Kane%20Credit%20Derivatives%20Explained%200301.pdf.
[viii] Id.
[ix] Mark Garbowski (2008-10-24). “United States: Credit Default Swaps: A Brief Insurance Primer” at http://www.mondaq.com/article.asp?articleid=68548.
[x] Please see http://www.probabilitytheory.info/topics/the_law_of_large_numbers.htm for a brief definition of the Law of Large Numbers generally.
[xi] David Teather. “The woman who built financial ‘Weapon of Mass Destruction.’” The Guardian at http://www.guardian.co.uk/business/2008/sep/20/wallstreet.banking?gusrc=rss&feed=business.
[xii] William Engdahl, “Credit Default Swaps The Next Crisis” at http://www.financialsense.com/editorials/engdahl/2008/0606.html.
[xiii] Taibbi, supra FN10.
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