The Role of Credit Default Swaps in the Recent Financial Crisis

The Role of Credit Default Swaps in the Recent Financial Crisis

Fogarty, Gilliam, Mullally, and Waldrop

Dr. Richard Fendler

FI 8000

July 29, 2009

While America’s recent financial crisis has had multiple effects, equally numerous are the theories regarding its cause.  One of the theories that has been discussed by academics, analysts, and journalists alike concerns the role that credit default swaps, a derivative originally designed to help hedge risk, played in financial crisis.  The reason that many observers have placed so much blame on the use of these credit default swaps, or CDS, is because of their prevalence in the financial market without government regulation.

By 2008, the credit default swaps market had ballooned to the point that approximately 62 trillion dollars had been invested in the global market of these derivatives--four times the value of all stock traded on the New York Stock Exchange.^[1] 

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Not only did the use of CDS contribute to the demise of many companies, most notably AIG, but because many of these default swaps were used by banks to insure mortgage defaults, the effects of having trillions of dollars in CDS were fully realized when subprime mortgages went bankrupt en masse.  Once buyers defaulted on a significant number of these mortgages, the crisis began as financial institutions had to place real values on these default swaps.  These worthless CDS quickly became known as “toxic assets.”  Many believe that the use of credit default swaps created a domino effect that sparked the entire financial crisis the entire U.S. financial crisis.  

        The idea of a credit default swap began as something fairly simple.  If a lender were fearful of a borrower’s defaulting on a long position, he negotiated to purchase a CDS from an outside party for some fee.  The two parties agreed that if the lender defaulted on his loan, the outside party (who sold the default swap) would then be responsible for taking over the loan.  So, for a fee, the outside party provided insurance, for an agreed upon time period, for a lender in case a borrower defaulted on a loan.  While many forms of credit default swaps had been developed and researched in the early 1990s, most attribute the beginning of the modern default swap to JP Morgan in the mid 1990s.  At the time, JP Morgan decided it would be in its best interest to develop a financial instrument that would help it hedge the risk it had undertaken by writing loans.  In 1997, JP Morgan created the first modern swap by splitting the loans it made to many large companies, most notably Ford, Wal-Mart, IBM, and Exxon, into “tranches.”  JP Morgan then identified the riskiest ten percent ‘tranche” and sold it to investors.^[2]  Soon after JP Morgan created the idea of a credit default swap, the market for these derivatives exploded as companies created CDS’ to provide a way for buyers to invest in emerging markets such as Indonesia and Russia.  While JP Morgan originally developed CDS as a tool to minimize risk, the market quickly grew to include what would become known as “naked” swaps.  Simply put, an investor with no investing interest in the underlying entity, whether the asset was a mortgage, a loan to a corporation, or a loan to a developing nation, could now purchase a default swap on that entity.  The investor was essentially betting that the owner of the asset would fall into default.  Therefore, instead of helping companies firms such as JP Morgan lower their exposure to risk, the explosion of the CDS actually created more risk, as the value of the written swaps far exceeded the value of the underlying assets on which they were written.^[3]