Credit Default Swap: Powerful force in financial crisis

European policy makers aimed for a voluntary Greek debt exchange that would not trigger the credit event

February 24, 2012

A Credit default swap (CDS) has emerged as one of the most powerful forces in the crisis faced by Greece and other members of the euro zone recently. European policy makers have looked cautiously at credit-default swaps, while they structured the Greek rescue over the last six months. They aimed for a voluntary debt exchange that would not trigger the credit event, fearing that payments on the swaps might set off destabilizing chain reactions through Europe’s financial system.

Credit default swaps were invented by Wall Street in the late 1990s as a form of insurance contract against the default of one or more borrowers. The original purpose of CDS was to make it easier for banks to issue complex debt securities by reducing the risk to purchasers. Credit default swaps became an alternative method of credit enhancement, apparently allowing investors to buy sub-prime loans and insure their safety. 

Between 2000 and 2008, the market for such swaps ballooned from $900 billion to more than $30 trillion. In sharp contrast to traditional insurance, swaps are totally unregulated. CDSs are not traded on an exchange and there is no required reporting of transactions to a government agency. During the 2007-2010 financial crisis the lack of transparency became a concern to regulators. They played a pivotal role in the global financial meltdown.

Credit default swaps are a type of credit insurance contract in which one party protect another party from the risk of default on a particular debt instrument. The purchaser of the swap pays an annual premium (like an insurance premium) for protection from the credit risk. Just as house insurance will cost more for those living next to a fireworks factory, a CDS becomes more expensive when the finances of the bond issuer deteriorate, such as in the Greek debt crisis.

If that debt instrument (a bond, a bank loan, a mortgage) defaults, the insurer compensates the insured for his loss. As with any insurance contract, there is scope for dispute about when a claim can be made on a default. Under a sovereign CDS, a claim depends on a “credit event”, which is defined broadly as a failure to pay interest, a moratorium on principal repayments or a restructuring of the debt.

Would a re-profiling of Greek debts — an extension of the maturity of debt to give the Greeks some breathing-space — qualify? It depends how it was done. If investors agree to such a deal of their own free will, as happened for Uruguay in 2003, it would not constitute a credit event. Nor would one occur if European banks succumbed to some arm-twisting by their own governments to agree to a swap. But a credit event probably would occur if all bondholders were forced into the switch. Should there be a dispute in the CDS market over a Greek reprofiling, it would be resolved by the International Swap Dealers Association (ISDA), a voluntary body which governs the market. Under ISDA rules, each region has a “determinations committee”, comprising ten bankers and five investors, which rules on such issues.  

The CDS insurer (which could be a bank, an investment bank or a hedge fund) is required to post collateral to support its payment obligation, but in the exuberant credit environment that preceded the credit crisis, this collateral deposit was generally too small. Some swap issuers ramped up their exposure to credit risk to unsupportable levels, without sufficient capital to back those obligations. For example, the large insurance company American International Group (AIG) reported in 2008 that they had sold over $400 billion of CDS contracts on subprime mortgages. 

This swap proved to be very profitable in the short term. Banks and other companies that issued them earned fees for insuring events they thought would never happen. But the losses produced by the end of the housing bubble were multiplied manifold, as the issuers of swaps found themselves faced with huge liabilities they had not prepared for. It was this cycle that brought down the insurance giant AIG in September 2008, which eventually needed $180 billion in taxpayer support.

CDS has become the subject of antitrust investigations in both the United States and the European Union. The investigations focus on whether the handful of big banks that dominate the swaps field have harmed rival organizations that could compete in markets for providing information and clearing swaps deals. The financial regulatory reform bill passed in 2010 called for the creation of new clearinghouses for derivatives, a class of financial transaction that includes credit default swaps. 

Swaps also became something traded in and of themselves, as a form of speculation. That kind of trading also landed investment banks in multiple and seemingly conflicted roles, as when Goldman Sachs helped sell bundles of mortgage-backed securities and then used swaps to bet that they would go belly up.