Many of you by now have no doubt heard something about relatively obscure investment vehicles called Credit Default Swaps and their role in the demise of the insurance jaugernaut AIG.  In the past, I suspect that few had ever heard of these or, if they had, were not very familiar with them. Admitedly neither was I. To my surprise, I found that this obscure market had grown exponentially over the the past 10-plus years to roughly twice the size of the U.S. stock market. That certainly encourages some questions: What exactly is a Credit Default Swap and how did they become the center of attention in these turbulent financial times?

What is a Credit Default Swap (CDS)?

In short, a CDS is a private contract between two parties similar to an insurance policy on a bond or loan. The “swap” is a bet on the financial health of the issuer of the debt and their ability to pay back the bond holder. These contracts often occur between banks, who are the bond holders who pay a premium to the issuer of a CDS such as AIG, in return for their promise to pay should the bond default .  Many banks use these ‘swaps’ to insure their bond portfolios in order to maintain capital requirements.

The concept of “swapping” risk, or uncertainty of future performance of an asset, is not unique. Many companies operating internationally engage in private contract currency swaps as a means of managing currency exchange rates. The same is true for managing interest rate fluctuations and commodity price fluctuations.

What went wrong?

Where did these assets go awry? Of the various types of debt that CDSs were written on, many included the now infamous sub-prime Mortgage Backed Securities (MBS) and Collateralized Debt Obligations (CDO). Once considered relatively stable asset classes (although we now know with erroneously strong credit ratings), these debt obligations became toxic when markets for these bonds dried up and they began to default.

In the case of AIG for example, unlike their property insurance division where probabilities of claims can be actuarially calculated and risk can be statistically measured, the burst in the real estate bubble and the subsequent rise in mortgage defaults was effectively a major earthquake whose damage was felt across the financial world.

Unlike insuring a home or car in which incidents are not highly correlated (i.e. the fact that your neighbor was in an auto wreck doesn’t increase the likelihood of you being in one), default rates tend to be much more correlated—or interconnected.  Instead of collecting a steady stream of premium payments, AIG was on the hook for billions of defaulted bonds.

AIG is not the only player in this market. Many other financial institutions and banks were lured into the lucrative market of issuing and trading Credit Default Swaps.  Well-known institutions like JP Morgan, Citibank and Bank of America have been major participants as well.

Why rescue AIG?

How have these once-obscure insurance instruments become the center of attention in this ‘crisis,’ and why did the government step in to save AIG?  The answer is because of the significant risk of a ‘domino effect.’  As CDSs became more and more prevalent, these private contacts between the debt holder and insurer morphed into a tradable commodity. In this ‘new’ market, contracts were bought and sold in the unregulated CDS market by those who speculated on the financial health of the underlyng company/asset.  In doing so, a web was formed tying together multitudes of financial firms and banks.

As concerns grew about the bond holder’s ability to collect should their underlying bonds default —particularly banks that purchased CDSs—so did the government’s concern that firms like AIG could potentially break down the world’s financial system should they fail. In order to prevent that from happening, the government stepped in—to keep the dominoes from falling.

What next?

In order to truly shore up the financial system, I believe toxic assets such as Credit Default Swaps will need to be addressed and possibly regulated.  Undoubtedly, the lack of oversight helped perpetuate the greed that ballooned the CDS market.

Investors are waiting to hear a concise plan from Treasury Secretary Timothy Geithner on how to deal with these toxic assets.  This matter continues to be the ‘elephant in the room’ that no one quite knows how to deal with.  Unfortunately, due to the breadth of these markets and inter-weaving of these institutions, government intervention in this market will likely be a necessary measure.

Dickens, Bill cropped

Billy D. Dickens, III, CFP®

Billy is the professional consultant for Doug Weber.