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Weapons of Mass Destruction?

Clearing up the confusion surrounding credit default swaps.

During times of financial distress, it's not surprising to see the media search for a culprit on which to pin the blame. In many recent reports, enemy number one has become a particularly important type of derivative--the credit default swap. Like many reports on complicated issues, the stories are partly correct, but they contain misunderstandings and misinformation.

There's no denying that the drawbacks of swaps placed additional risk burdens on the financial system and threatened to magnify its troubles. Bear Stearns, Lehman Brothers, and  American International Group (AIG) were big players in the swaps market. Each of those firms was a counterparty to untold numbers of contracts. In effect, they each were acting as substitutes for the role of an exchange. Had a more disorderly collapse of any of them or other firms been allowed to occur, it's unclear just how badly and how far the damage would have stretched.

But the suggestion that the financial crisis was triggered by a specific failure in the swaps market is incorrect. Out-of-control leverage--which was taken on through many different methods, including but not limited to swaps--and lax lending standards have been rampant across the market. Failures in the mortgage finance system arguably deserve the lion's share of blame.

Lost in all the hubbub has been a more nuanced look at what the risks to our financial system actually are and what can be done to address them--without throwing the baby out with the bath water. That's important because the fact is that derivatives, and especially swaps, have made a valuable contribution to the expansion, efficiency, and utility of our financial markets.

What's a Swap?
In its most basic form, a swap is a contract between two parties to exchange one thing or another. In the case of a plain-vanilla interest-rate swap, for example, two parties might have mismatched assets and liabilities. Assume that Party A has taken out a loan and must pay a fixed rate of interest, but it also receives a stream of income that pays a floating rate to Party A. Party B, by contrast, owes money on a floating-rate loan, but it has an income stream that pays a fixed rate. Each party would prefer to swap its payment stream, so that both its assets and liabilities are matched--either fixed to fixed or floating to floating. With a swap, each party can eliminate the risk that its income may not be sufficient to meet its payment obligations. Assume that both parties choose the same dollar amount upon which to base the swap, called the "notional" value. One party agrees to make a fixed interest payment based on the notional value, while the other agrees to pay a floating rate.

What makes things interesting is that, while the notional value is important as a reference point, the actual amount almost never changes hands. Rather, it's only the interest payments based on that number that flow back and forth. In fact, the contract can be structured in a way that those interest payments will offset each other to some degree. For example, take a swap with a notional value of $10 million, where the fixed rate is 6% and the floating rate is at 5% at the time payments are due. The payments are "netted" (6% minus 5%); the fixed-rate payer owes 1% of $10 million to the floating-rate payer, a payment of $100,000.

Often, the only other money involved is margin collateral that the parties put up to cover the risk that they will fail to live up to the contract. That's why it's worth taking numbers you hear about the size of the swap markets with a grain of salt. A $60 trillion notional amount of swaps may represent plenty of risk being transferred or embedded in the financial system, but it doesn't mean that 60 trillion actual dollars ever traded hands.

There are all kinds of reasons that an investor would want to use an interest-rate swap, and they run the gamut from saving money to hedging risk and speculating. In many cases, investors can get similar results from futures or options, but they may turn to customizable swaps to negotiate a longer maturity, or for other needs.

Credit Default Swaps: The Basics
Thus, a credit default swap is essentially a legal contract that involves the transfer of a given risk (in this case credit risk) from one party to another for a specified period of time and under specific terms. Less abstractly, think of it as an insurance contract that is also a risk-transference device. In a simple CDS transaction, for example, a "protection purchaser" might have credit concerns about a corporate issue the purchaser holds, say a long-maturity General Motors bond. The purchaser buys the CDS from the "protection seller." The seller takes on the risk that GM will default in exchange for periodic premium payments, which represent the cost of the CDS to the purchaser. If GM were to default on the issue, the CDS seller would be obligated to make the purchase whole, depending on the terms of the contract.

In the language of derivatives-speak, the buyer has been able to put the credit risk--but not the interest-rate risk--of the underlying credit to the seller, while still maintaining ownership of the underlying issue. Or the buyer is "short" risk and the seller is "long." In this way, CDS instruments allow for the disaggregation of credit risk from other types of risk. The cost of the CDS for the purchaser will vary depending on the terms in the agreement and the degree of risk that is perceived in the marketplace.

The Shifting CDS Marketplace
The CDS marketplace originated to provide banks and other institutions with the flexibility to transfer credit exposure and hedge underlying risks. Over time, the smooth functioning of this marketplace attracted the attention of investment-management firms. Soon, sophisticated tools were required to run increasingly complex strategies. A watershed moment for credit default swaps was the market's ability to handle large, high-profile settlements after the blowups of WorldCom and Enron. Investors became more confident in the instruments, and they since have become important tools for fixed-income investors.

The market for credit default swaps is huge and has expanded at a rapid clip. In 2007, the credit derivative marketplace was estimated to have a notional value of close to $60 trillion, which is significantly larger than the market value of the underlying corporate bonds themselves. Originally, the market could be divided into three sectors: corporates, bank loans, and emerging markets. More recently, the CDS market has expanded to encompass municipal securities and subprime mortgages, among other areas. Moreover, in addition to single-name default swaps, some of the most commonly traded contracts are built around index baskets of multiple securities. They come with esoteric names--CDX, ABX, CMBX, and the like--and dizzying inclusion methodologies.

Credit default swaps loom large because they're often the preferred tool for managers and financial institutions looking to control or hedge portfolio risks. Common credit events that credit default swaps are used to protect against include: bankruptcy (the firm becomes insolvent and is unable to pay), default (the firm fails to make a timely interest or principal payment), and debt repudiation (the issuer of the underlying bonds rejects the debt as valid, which can occur particularly in emerging markets, as a form of political risk). The settlement of a CDS typically involves either an exchange of the underlying securities for their par value, or it can occur in the form of a cash payment that makes the purchaser whole as of a given date, essentially paying the difference between a bond's market value and par value.

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Eric Jacobson does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.