What is a credit default swap?

A credit default swap (CDS), also known as a credit derivative contract, is a financial contract in which the seller of the CDS is obligated to pay the buyer in the case of a third party credit default. Multi-billionaire Warren Buffett called these contracts ‘financial weapons of mass destruction’.

The best way to view a credit default swap is as insurance protection against a third party borrower defaulting on its debts.

If a credit default occurs, then the seller of the credit default swap usually pays the buyer the face value of the product, and the seller assumes the ownership of the fixed income security in the form of a CDS.

If there is no credit default, then the buyer of the credit default swap is obligated to make quarterly payments to the seller until the CDS reaches maturity.

Credit default swap no defaultIn the case that no credit default occurs.

credit default swap defaultIn the case that a credit default occurs. 

Credit default swaps essentially allow market participants to hedge credit risk.

The credit default swap market is currently not regulated by any government.

With the CDS market available, banks and hedge funds are able to lend out billions of dollars without having to worry about their reserves as security.


After 2008 CDSs became much less popular

During the 1990s and up to the global financial crisis of 2008, CDSs became extremely popular – many say perhaps too popular. A market that had initially been dominated by banks to hedge the risk in their corporate books soon spread to traders who grabbed the opportunity to use CDSs as a way to speculate on the future movements of the market.

By 2005, traders and banks were also using CDSs to bet and hedge on the future performance on several types of mortgage securities. When the housing bubble popped and the value of mortgage securities started to plummet, investors who had written CDS protection on mortgage-related investments found themselves on the hook to the tune of hundreds of billion’s of dollars’ worth of payouts on the CDS contracts they had sold.

Giant insurer AIG had to be bailed out by the American taxpayer, and as Tracy Alloway wrote in Bloomberg.com “and CDSs’ reputation as ‘financial weapons of mass destruction’ was apparently sealed.”

After the global financial crisis, the popularity of CDSs fell significantly and new regulations effectively reduced big banks’ ability to deal in the products.

Video – What are credit default swaps