Explaining Credit Default Swaps
Joe Garrett, my partner and I live and work in the San Francisco Bay area. The Bay Area is home to two great Universities, Cal and Stanford. Both Joe and my youngest son attended Cal. The weather is perfect most of the year. I’m able to ride my mountain almost every day, even in the dead of winter. We have wine, waves and wacky people. On our way back from a party in the wine county this weekend, we took this picture before crossing the Golden Gate Bridge into San Francisco.
What do you think?
Over the weekend I listened to Bob Brinker do a great overview of Credit Default Swaps (CDSs) and their contribution to the financial meltdown of 2008 and 2009. If any of you are interested in listening to a very concise explanation of CDSs, visit his web site at and listen to the first monolog on Saturday, December 12. In addition, the Wall Street Journal ran a piece in the weekend issue on the same topic, specifically how Goldman and AIG are key characters in the mess.
In short, CDS are a type of insurance policy that protects bond holders in the event of a default. Let’s look at a simple example of the use of a CDS and what happens when the underline assets losses value.
A Wall Street firm aggregates subprime mortgages and creates a mortgage related securities with various risk traunches. The highest quality piece might account for 60% - 80% of the security and is sold to commercial banks as investment grade bonds. This traunch is the least risky to default and investors receive an AA rated yield. The other 40% is divided into several risk traunches and sold off to yield hunger investors who are willing to take on higher risks for a higher yield. Some of the investors in the high risk traunches are worried about a default and purchase insurance to protect itself if the underline asset loses value and becomes worthless. They find an entity that writes a policy to protect the bond holder if there is a default. What’s interesting is anyone can write a policy to protect the bond holder. The bond holder must be confident that the insurer has the financial capability to cover a potential claim. AIG was a very large player in the CDS market.
Evidently there is little regulation on CDS and we’ve heard the capital backing the insurance might be 30:1. When the subprime and Alt A securities started to lose value and bond holders made claims to the writers of the CDS, the entire market started to unwind. Some of the insurers did not have adequate capital to stand behind the policies. Simply put, there was “no there there”.