Understanding Credit Default Swaps: Why Banks Were Attracted During Housing Boom and Risks Involved
Understanding the dynamics of Credit Default Swaps (CDS) is crucial, especially when examining the tumultuous period of the housing boom. CDS are a type of derivative financial instrument similar to a call or a put option, used primarily to transfer credit risk from one party to another. However, their misuse and overuse played a significant role in the 2008 financial crisis. In this article, we will explore the reasons why banks were attracted to CDS during the housing boom and why no one seemingly dared to stop the practice, despite the evident risks.
What are Credit Default Swaps?
Credit Default Swaps (CDS) are essentially insurance against the potential default of a bond or loan. When a CDS buyer pays a fee, they can transfer the credit risk of a loan to a CDS seller. This allows the buyer to be compensated in the event of a default, typically with the full notional value.
How CDS Work
To illustrate, let's consider a practical example. Suppose a bank wrote a CDS for $1 million with a buyer, charging $5,000 for the insurance. If the borrower defaults and cannot pay back the principal and interest, the bank would receive $1 million from the CDS counterparty. This essentially means that a company or a bank can receive a huge payoff without having to do extensive servicing or lending out any principal.
Why Banks Were Attracted to CDS During the Housing Boom
During the housing boom in the early 2000s, banks such as the bank were comfortable lending significant sums to companies like WorldCom, Arthur Andersen, and Enron. Despite initial comfort, these banks faced unexpected credit risks. A u003cREFERENCE_TO_INVESTOPEDIAu003e can help illustrate that CDS could help offset such risks by centralizing loan servicing and underwriting.
Real-World Example: In the case of WorldCom, the bank, instead of lending $20-30 million, chose to write CDS that offset the credit risk with counterparties. This approach provided a more efficient way to manage risk compared to a syndicated loan, which was shared among several banks.
Insurance companies, like AIG, were particularly attracted to CDS as they offered a less labor-intensive alternative to traditional private lending and provided better returns than bonds. This made CDS an appealing instrument for both lenders and borrowers, as it allowed banks to reduce the overall cost of borrowing by centralizing loan servicing and underwriting.
Why No One Stopped Them From Doing It
The problem arose when CDS usage went beyond their intended purpose. Banks started writing CDS that were multiples of the underlying credit, creating more risk than usual. For example, a mortgage-backed security with a notional value of $1 million might have $5 million in CDS written against it. This scenario is analogous to betting heavily on an event, resulting in a much higher potential loss in the event of default.
Banks did not primarily buy CDS; the primary buyers were insurance companies like AIG, which needed additional income to meet their reserves. Goldman Sachs, as a counterparty, likely profited from these CDS, with the firm reporting record profits shortly after the financial crisis. The immensely complex nature of CDS and the lack of regulation meant that no one effectively regulated the market, leading to growing systemic risks.
Risk Management and Systemic Risks
Until the 2008 financial crisis, the risks associated with CDS were not fully understood. Historically, conforming mortgages had a very low default rate, around 0.15-0.25 annually. However, the underlying credit risk had increased, and no one was tracking how many insurance contracts were written against a single bond or borrower. This oversight is a major systemic risk that can only be addressed through better regulation and transparency.
Key Points to Note: No tracking of CDS on an active exchange like stocks. Lack of central regulation and oversight. Inadequate understanding of the true risks involved by rating agencies.
Today, regulators like the Fed and the OCC should conduct more thorough tracking and analysis of CDS, but currently, this is not the case. The derivatives market remains a grey area, further emphasizing the need for stringent and transparent regulations to prevent another financial crisis.
Understanding the risks and misuses of CDS during the housing boom is crucial. By learning from past mistakes, we can work towards a more stable and transparent financial system in the future. As markets continue to evolve, it's important for both investors and regulators to stay vigilant and proactive in identifying and mitigating the risks associated with complex financial instruments.