Credit Default Swap: The Inconvenient Truth

In the early 1990s, J.P Morgan Chase & Co. (J.P. Morgan & Co. then), invented credit default swaps (CDS) to hedge their loan risks. CDS is basically an insurance contract between insurance buyer and insurance seller. The essence of the insurance contract is: the insurance seller will guarantee repayment to the insurance protection buyer should borrowers (corporations and sovereign states) default on their loans. The buyer of the insurance pays unfornt amount and yearly premiums in exchange of the protection. CDSs are traded over-the-counter (vs. standardized contracts) and are subject to counterparty risk. If the party providing the insurance protection doesn't have the money to pay the insured buyer in the case of a default event affecting securities, or if the insurer goes bankrupt, the buyer of the insurance is left hanging.

The initial intent of this particular derivative was risk management: hedging the risk of default. However, an increasing number of market participants began to use CDSs for speculation by betting whether a party will be able to meet debt obligation or go bankrupt. As it becomes more likely that a company or a sovereign state will default on their loans (the risk of default goes up), the CDS prices will go up and the speculator can now sell CDS at a much higher price to someone who seeks to protect himself against the default risk. On the other hand, if it is unlikely that a corporation or a sovereign state will default on their loan, a speculator can sell an insurance policy and collect all premiums from protection buyers.  It's a pure speculation on a future event. And often times, it created a perverse incentive in the system: it significantly reduced a lender's incentive to do a thorough due dilligence since it can simply buy CDS and get all the protection it needs.

The problem is that CDSs were written on subprime morgage securities. The ones that buyers are having trouble repaying the loans let alone interests.. Many financial institutions are sitting on assets that are only worth a fraction of every dollar from mounting foreclosures and excess house supplies. To make matters worse, however, speculators traded trillions of dollars of insurance that these pools of mortgages wouldn't default. Who knew real estate related investments can turn out to be such a disappointment? AIG is an insurance company that sold hundreds of billions of dollars ($441 billion to be exact) of CDS on corporate bonds and mortage related securities. Then subprime mortgage crisis hit the system and AIG had to be bailed out. Otherwise, those buyers of CDSs would have to write down hundreds of billions of dollars worth of assets on their balance sheets, thereby creating a huge systematic problem. The federal government lended around $180 billion to AIG alone. The time is slowly coming for AIG to start repaying the bailout money, and all the news we hear is that AIG is trying to liquidate as many assets it holds to stay liquid.