FINANCIAL MISCONDUCT: What are credit default swaps?

Steve Lombardi

Attorney
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Credit default swaps are a way of insuring credit instruments (loans) that make it easier for the lenders to sell the loans to investors. As the name implies the insurance is to protect the investor who buys the loans in the event of a default. The investor or investment banker give a part of what they expect to make in profit to insure the loan investment. This allows or creates a market of willing buyers. Without credit default swaps the investors would not be interested in buying the loans or loan portfolios without a comprehensive evaluation of the borrowers’ credit worthiness. This is called liquidity. Liquidity is the ease of an investment being bought and sold on the open markets.

In the case of large corporations borrowing billions of dollars it makes lending them the money an easier proposition because risk of default is being spread around to several other financial companies. The fee is like an insurance premium. A lot of rating the CDS depends on the rating of the insurer. Companies like Berkshire Hathaway have a lot of money sitting idle and they do get involved. The better the rating on the insuring company the higher the quality of what would otherwise be a higher risk investment.

It’s like your brother wanting to borrow money from you. Let’s say it’s $100.00. Your brother has no job and no savings. You’re not likely to lend him the money. But if your father said he would pay you back if your brother reneged then you’d be more willing to lend to your brother. Your risk comes in with Dad not being able to cover the $100.00 when your brother defaults on the loan.

So what happened that made things go wrong in America?

Let's start with switching AIG for Dad. American International Group is a huge company. If AIG has too much debt-insurance or is undercollateralized with covering their own debt, then AIG may have problems if their assets become devalued and their lenders demand more collateral. If there Moody's rating drops that will mean AIG will need to pay more for borrowed money. That's not good because if they calculate what they can afford to insure at one interest rate and that interest rate changes the investment can turn upside down.

Now so long as the rating company doesn’t catch on to what AIG is doing with insuring debt then AIG’s rating won’t change. But if Moody’s gets wind of what is insured they might change AIG’s rating; causing the cost of insuring credit default swaps to increase dramatically causing problems for everyone taking part in this investment scheme. Fact of the matter is, there is evidence to suggest that some hedge funds had bet against AIG surviving. This was a huge gamble with a foundation made of clay. The assumptions proved wrong and so went the investment. Problem is we really don't know how bad this is all going to turn out. Not even Buffet can predict what will happen.