Credit Default Swaps - How the Arsonists Collect the Insurance

What is a credit default swap and why have they been in the news recently and why are they to blame for much of the current insolvency of financial institutions?
The Credit Default Swaps (CDS) have been described as insurance policy against defaults on the underlying assets. That is not exactly what they are but it’s not a bad description.

CDS were designed for those who owned debt obligations (for example corporate bond holders) to hedge on their investment so they would not lose so much should the company whose bonds they purchased went bankrupt and did not payoff on the bonds. They would be able then to collect on the CDS and would not lose as much if any.

The problem with them is two fold. 1. unlike an insurer who is required by regulation to keep a certain amount of capital in reserve to pay any possible future claims, those who sell the swaps are not required to keep any money in reserve to pay possible future obligations that come due when there are defaults on credit obligations. Those selling the CDS believed the chance of default on the underlying debt obligations (mortgages) to be near zero and that is about the amount of money they set aside to pay off these “insurance policies”. and 2. one need not hold the underlying asset in order to purchase the swap (insurance).

AIG and like institutions could therefore sell swaps on one asset to thousands of buyers and they did exactly that. They are not sold on specific mortgages but on underlying packaged derivative securities (think of holding stock in the right to receive payment on a group of mortgages) however allow me an example that uses a mortgage.

If you default on your 200k mortgage the loss to the bank would be the amount of your loan that was unpaid plus the cost it took them to foreclose and own the home until they sell it minus what they sell it for. Lets say that you owed 200k, it cost the bank 20 k to get through the foreclosure process and own the home for a year, and they then sold the house for 120k. They have lost 100k.

However if you default on your 200k mortgage and 100 swaps were sold on the mortgage the total loss is 20 million. Multiply this small scenario by the hundreds of thousands and you will have an idea of why AIG can burn through billions and billions in a short period of time.

Add to this the fact that in many cases those buying the swaps often were those involved in packaging and selling the underlying securities. Giving them incentive to actually package bad securities, make money selling them and then making money again when collecting on the swaps. For example a wall street firm could buy a bunch of mortgages that they knew were likely to default, package them together, pay S and P and Moody’s to rate them AAA. (That is another story, those who create securities are the ones who pay the rating agencies to rate them – talk about a conflict of interest) They then sold these securities to buyers who bought what they thought were safe investments based on the ratings of these agencies. All the while those who sold the securities were buying hundreds of thousands of CDS betting that there would be massive defaults. They not only collected insurance when their neighbor’s house burned down, they poured the gasoline and lit the match and still collected.