Credit Default Swap (CDS)
A derivative instrument originally intended to allow an investor to transfer the risk of default, though in 2008, investors also began to use them to speculate on a particular firm’s credit risk. They are essentially Insurance against the risk of bankruptcy of a firm, a country or a non-government local authority; the buyer of a CDS pays an annual premium to the seller and receives a pre-agreed sum should the debt default.
In principle, the buyer of a CDS would be the holder of the underlying credit, whilst the seller would normally be a bank, hedge fund or an insurance company.
The underlying asset could be a corporate, government, a non-state agency or even a pool of collateralised debt obligations (CDO’s).
Trading Credit Default Swaps
The protection covers the risk of default by a bond issuer (the reference entity), for a specific tenor, (time period) which is usually 5 years in the interdealer market.
For CDS structurers, the tenor can be different, though the swap would normally match the maturity of the underlying bond issue. [If they do not coincide, both cash flow and yield calculations will be extremely difficult to calculate].
Only if a credit event occurs (under pre-agreed conditions) would the premium payments cease before maturity.
A credit event is triggered by, amongst other things, bankruptcy, failure to pay or repudiation of or a moratorium on debt by the reference entity.
In this situation, the seller of protection agrees to buy the bonds of the failed issuer at par (or 100% of face value), though this is more complicated if the CDS buyer did not own the underlying bonds-this entailed them participating in the auction for that debt, with limited certainty as to the price they would be paying.
If the auction price was $0.1 per dollar of debt, the protection provider would be liable for the remaining $0.90 of the outstanding $1 face value of the bonds.
Over time cash settlement became the norm, as this limited the ability of both sides of the contract to manipulate the auction results in their favour.
Origins Of Credit Default Swaps
The first CDS was introduced by JP Morgan in 1995- by mid-2007, there was more money invested in CDS’ than in US equities, mortgages and US Treasuries COMBINED.
The events of 2007-09 showed that diversification (i.e. selling a wide variety of protection in differing sectors etc.) was ineffective, as large numbers of entities defaulted simultaneously.
The lack of regulation allowed sellers of swaps to engage in this strategy despite limited capital available to cover defaults, meaning that a concentrated burst of credit events overwhelmed those sellers, who then defaulted on their obligations in turn.
Thus, holders of Swaps ultimately had a false sense of security; the protection they thought they owned proved illusory, as Washington Mutual found when the CDS protection they owned was negated by the bankruptcy of their counterparty, Lehman Brothers.
Risk was not thereby eliminated as supposed, but merely transformed into something else.