What is a CDS?
A credit default swap is an agreement made between two parties in which the seller of the credit default swap (or CDS) agrees to make a payment to the buyer if a "credit event" occurs.
So what does all of that mean? The basic idea behind a credit default swap is best illustrated through an example or two.
Example #1. You are a very wealthy person who happens to own $100 million worth of XYZ Bank bonds. These bonds return you an average of 3.25% per year.
XYZ Bank is a seemingly bulletproof company that has been around for years. Massive base of depositors, steady earnings, etc.
Still though - you would like to hedge against the unexpected. If a company like Lehman Brothers can go under, then it could happen to XYZ Bank.
In order to hedge your position, you agree to purchase a credit default swap through a counterparty. The transaction is set up by your broker.
You and your counterparty agree on a five year contract.
If XYZ Bank defaults on its bonds between now and the end of the five year contract, then the counterparty will pay you $100 million.
In return, you will pay an annual premium of 50 basis points (or 0.5%, or $500,000) per year.
At the end of the five year period, the contract will expire. If XYZ Bank doesn't default, then you will have paid $2.5 million but gotten nothing in return (just paying for car insurance but not getting into an accident). In your mind, sacrificing 0.5% of your annual return in exchange for hedging your position is worth it.
Your counterparty will make a fairly low-risk $500,000 per year in annual premiums, but they run the risk of being on the hook for the entire $100,000,000 payment if XYZ Bank defaults.
Example #2. You are an aggressive trader who believes that XYZ is going to go under.
XYZ is an investment bank that has been around for many decades. You have closely inspected their balance sheet and believe that they are unbelievably vulnerable to any type of downturn in the real estate market.
You decide to purchase a credit default swap on XYZ, even though you don't own any of their bonds. This will be a strictly speculative position.
You enter into an agreement with a counterparty for $1 billion worth of protection.
If XYZ defaults between now and 2015, then you will be entitled to a $1 billion payment.
In exchange, you will be expected to pay an annual premium of 100 basis points, or 1% ($10 million).
if XYZ runs into trouble and defaults between now and 2015, then you will collect $1 billion. If they don't default, then you will be out a total of $10 million x the number of years in the contract
If you are wondering how John Paulson made his money in 2007, it was through credit default swaps. Paulson placed bets against the US real estate market using these swaps, and they ended up paying off handsomely.
A number of companies (namely AIG) were ruined due to selling credit default swaps. When the economy and real estate market were rolling along, selling credit default swaps was basically free money. However, when things started to turn, AIG was on the hook to their counterparties for an insane amount of money, which resulted in the company collapsing and needing hundreds of billions of dollars in bailout money from the government.
Credit default swaps caused so many problems during the 2008 meltdown because:
1) they are unregulated
2) sellers aren't required to maintain proper reserves in order to pay off their obligations in the event of default
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