What is Credit Default Swaps?

Credit Default Swaps (CDS)

• Definition and Purpose:
  • Credit Default Swaps are financial derivatives that act like insurance policies against the default of debt issuers. They were designed to provide investors with protection against the risk of a debtor failing to make payments.
• Operation:
  • In a typical CDS transaction, one party (the protection buyer) pays a periodic fee to another party (the protection seller), in this case, AIG. In return, the protection seller agrees to compensate the buyer if the debt issuer defaults.
• AIG’s Involvement:
  • American International Group (AIG) was one of the largest sellers of these swaps. It sold trillions of dollars in CDS protection, covering a wide range of debt securities, including those backed by subprime mortgages.
  • Despite the vast volume of swaps it sold, AIG maintained only a few billion dollars of capital reserves, a fraction of the potential payouts in the event of widespread defaults.
• Risks and Consequences:
  • The imbalance between the volume of swaps and AIG’s capital reserves meant that when defaults began to occur during the financial crisis, AIG was unable to cover all the claims. This led to a liquidity crisis at AIG, requiring a federal bailout to prevent its collapse and further destabilization of the financial system.

Leveraging

• Definition:
  • Leveraging in finance means using borrowed money to increase the potential return of an investment. Investors borrow funds at a lower interest rate to invest in assets that they expect to yield higher returns.
• Mechanism:
  • For example, if an investor borrows $1 million at an interest rate of 3% and invests it in assets that earn 6%, the investor stands to make a significant profit on the borrowed money after paying back the interest.
• Risks:
  • While leveraging can significantly amplify profits, it also increases risk. If the value of the leveraged assets declines by even a small percentage, the investor can face substantial losses.
  • The risk is that a small drop in asset value can proportionally have a much larger impact on the investor’s equity. For example, a 10% drop in asset value in an investment leveraged 10:1 could completely wipe out the investor’s capital.
• Impact on the Financial Crisis:
  • During the run-up to the financial crisis, many investors used leveraging to purchase larger quantities of risky assets, including mortgage-backed securities and other derivatives.
  • When housing prices fell and mortgage defaults rose, the drop in the value of these assets quickly depleted investor capital, exacerbating the crisis.

These expanded sections provide a clearer view of how credit default swaps work and why leveraging, while a powerful tool for amplifying returns, also significantly increases financial risk, contributing to the severity of the financial crisis when markets turned downward.