Credit Default Swaps and the Credit Crisis (Digest Summary) (2024)

Credit Default Swaps and the Credit Crisis (Digest Summary) (1)
  1. Lee M. Dunham

The author reviews the credit default swap market and investigates its role in the financial crisis. He concludes that the financial crisis was not caused by credit default swaps directly but driven by falling real estate prices and financial institutions operating with too much leverage.

The exponential growth of the credit default swap (CDS) market over the past few years is well documented. The Bank for International Settlements reports that the CDS market increased in size (measured by notional principal) from $6 trillion in 2004 to $57 trillion in June 2008. The highly publicized government bailout of AIG brought the CDS market to the media forefront, and some observers have identified the CDS market as the primary cause of the financial crisis. The author discusses the institutional detail of the CDS market and examines the role of the CDS market in the financial crisis. He concludes that the most significant problems underlying the financial crisis were not directly caused by CDS but rather by a combination of the dramatic decline in the real estate market and highly levered financial institutions holding large investments in subprime securitizations.

A CDS is simply an insurance contract against the default of a particular company or referenced entity. Although many observers compare CDS with insurance contracts, the author points out two key differences between the two products. First, although buyers of standard insurance contracts are required to hold an insurable interest, buyers of a CDS are not. As a result, it is not uncommon for the total notional principal of an entity’s CDS to exceed the value of that entity’s outstanding debt. Second, CDS contracts are traded, whereas standard insurance contracts are not. The author points out that trading CDS contracts should theoretically make the cost of capital cheaper for companies because the CDS market allows the separation of credit risk from the cost of funding. In the past, lenders had to bear credit risk, but the CDS market makes it possible for lenders to transfer credit risk to those most willing to bear it. Although this market allows for better risk allocation, it may also result in some incentive problems. For example, a lender that makes a large loan to a risky borrower can purchase CDS protection, and this protection ultimately lessens the incentive for the lender to monitor the borrower. Furthermore, an owner of a company’s bonds may be willing to negotiate a settlement if the company is facing financial distress. If that owner purchased CDS protection, however, then the investor may have an incentive to steer the company into bankruptcy to receive a higher payout.

Despite the media storm surrounding the CDS market, the CDS market actually worked quite well during much of the financial crisis. As evidence, the author points to the orderly process of the Lehman Brothers default in which CDS written on Lehman were settled with relative ease. To understand the disparity between why the CDS market worked during the financial crisis and its reputation as a dangerous product, the author points out that regulators permitted financial institutions to hold less regulatory capital if they held loan securitizations with CDS protection on their balance sheets rather than on the underlying loans. When the subprime CDS market began to experience losses, observers were quick to blame the CDS contracts. It was not the CDS contracts themselves that caused the losses, however, but the increase in defaults on the underlying subprime mortgages and the disappearance of liquidity for these securitizations. Furthermore, CDS were not the cause of failure for Lehman and Bear Stearns. Although both firms were dealers in CDS, their books were fairly balanced with trades on both sides and collateral agreements were generally in place. AIG was different. Its books were not balanced because it mostly sold protection. Additionally, AIG was heavily leveraged when it purchased a portfolio of subprime securitizations. In fact, the losses on its portfolio of mortgage-related securities exceeded the losses on its credit default swaps.

Lastly, the author investigates the pros and cons for having CDS traded on exchanges. Although a clearinghouse could reduce risk associated with the failure of individual counterparties and also limit the amount of additional exposure taken on by a particular counterparty, the CDS market is fairly customized. This customization allows the OTC market to be more innovative as it relates to developing products. In the end, similar to the currency market, the optimal solution might be an exchange and an OTC market operating simultaneously to bring together the best characteristics of both markets.

Publisher Information

CFA Institutedoi.org/10.2469/dig.v40.n2.37ISSN/ISBN: 0046-9777

Credit Default Swaps and the Credit Crisis (Digest Summary) (2024)
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