Weblog
What is a Credit Default Swap?
We’ve all heard about Credit Default Swaps, and how they’re the great bugaboo that could rear up and kill the entire world’s economy. Warren Buffett called them “financial weapons of mass destruction.” Since that’s pretty scary, we should all have a clever metaphor for explaining what they are.
Credit Default Swaps (CDS) are like you buying fire insurance on your neighbor’s house. You have nothing to do with your neighbor, nothing to do with their house, but you think you have a pretty good idea about whether or not their house might burn down. So you find someone else who will take a fire insurance premium payment from you every month for 5 years. If the house burns down, you get paid. If not, you paid a bunch of premiums and got nothing in return. You made a bet, and you will win or lose.
Let’s extend this metaphor a bit. Suppose you built a clever model that showed that the 1,000 houses in your neighborhood each had a 1% chance of burning down in the next 10 years. If you could buy fire insurnace on all 1,000 houses such that the cost of the insurance was less than what your model showed you would make when 1% of them burned, you’d have a pretty good bet. In theory, you’d have a winning bet. You might even be able to sell your side of the bet to someone else, who would then take over the premium payments. Free money!
Naturally, the person selling you the insurance would be a fool who built a lousy model and shouldn’t have sold you the insurance in the first place, since when all of those houses burn they’ll have to pay you a fortune. Maybe they’ll even go bankrupt as a result of having to pay you for your neighbors’ burned-down houses!
Or maybe the person on the other side of the bet, to whom you pay premiums, will sell the insurance policy to someone else, who you don’t even know! You’ll be paying every month, and then when the houses finally burn down, the person who owns the insurance policy turns out to be just some loser, like a bank in Iceland or something. They’re broke, you’re out the premiums you’ve paid, and no one benefits from the burned-down houses.
Let’s kick this up to Defcon 5. Suppose that everyone is selling everyone else these crazy insurance policies on other people’s houses. The Credit Default Swap market is estimated at $58 trillion. That’s nuts!!! The entire world’s publicly traded equities and debts are worth only $35 trillion.
In actuality, Credit Default Swaps are like fire insurance on municipal and corporate debt, and on mortgage-backed securities. If the municipality issuing the bond goes into default, then the person paying the monthly premium on the CDS wins the bet, and the person taking the premium has to pay.
Of course, it’s only when municipalities and other bond issuers start to default in huge numbers that you can see whose clever model is better, and who is toast. Unfortunately, if the people with worse models don’t have any money, then the “winners” are toast too. These “winners” then have to write down the value of their CDS assets, meaning they have to take them off their balance sheets. This reduces their assets, possibly affecting their credit ratings, possibly causing a run on their assets by nervous investors, possibly destroying the entire planet.
In reality, the government will step in and regulate the CDS market. One possibility, for example, is that you can only buy fire insurance on your own house. Another is that the rules around how to value these insurance policies will become transparent, so that banks can’t fill their balance sheets with nonsense that can evaporate overnight.
Then we can safely go back to hearing on TV about how some other country’s economy is imploding, and not ours. And then we have nothing to worry about.
By the way, clients of Ross Asset Advisors were (and are) protected better than most from these problems. This is because I use 2-year globally-hedged government debt (or its municipal equivalent) as the majority of my bond allocation. The fund I use is up 2.09% YTD as of October 16. These instruments are not exposed to any company that is encumbered by Credit Default Swaps. The purpose of bonds in a portfolio is to provide stability and ballast, so that risk can be taken with equities. Longer term and corporate bonds have not been demonstrated as being useful in this regard, since they have volatility almost like equities, but much lower returns.
