Subprime Crisis Background Information - Credit Default Swaps and The Subprime Mortgage Crisis

Credit Default Swaps and The Subprime Mortgage Crisis

Credit defaults swaps (CDS) are insurance contracts, typically used to protect bondholders from the risk of default, called credit risk. As the financial health of banks and other institutions deteriorated due to losses related to mortgages, the likelihood that those providing the insurance would have to pay their counterparties increased. This created uncertainty across the system, as investors wondered which companies would be forced to pay to cover defaults.

For example, Company Alpha issues bonds to the public in exchange for funds. The bondholders pay a financial institution an insurance premium in exchange for it assuming the credit risk. If Company Alpha goes bankrupt and is unable to pay interest or principal back to its bondholders, the insurance company would pay the bondholders to cover some or all of the losses. In effect, the bondholder has "swapped" its credit risk with the insurer. CDS may be used to insure a particular financial exposure as described in the example above, or may be used speculatively. Because CDS may be traded on public exchanges like stocks, or may be privately negotiated, the exact amount of CDS contracts outstanding at a given time is difficult to measure. Trading of CDS increased 100-fold from 1998 to 2008. Estimates for the face value of debt covered by CDS contracts range from U.S. $33 to $47 trillion as of November 2008.

Many CDS cover mortgage-backed securities or collateralized debt obligations (CDO) involved in the subprime mortgage crisis. CDS are lightly regulated. There is no central clearinghouse to honor CDS in the event a key player in the industry is unable to perform its obligations. Required corporate disclosure of CDS-related obligations has been criticized as inadequate. Insurance companies such as AIG, MBIA, and Ambac faced ratings downgrades due to their potential exposure due to widespread debt defaults. These institutions were forced to obtain additional funds (capital) to offset this exposure. In the case of AIG, its nearly $440 billion of CDS linked to CDO resulted in a U.S. government bailout.

In theory, because credit default swaps are two-party contracts, there is no net loss of wealth. For every company that takes a loss, there will be a corresponding gain elsewhere. The question is which companies will be on the hook to make payments and take losses, and will they have the funds to cover such losses. When investment bank Lehman Brothers went bankrupt in September 2008, it created a great deal of uncertainty regarding which financial institutions would be required to pay off CDS contracts on its $600 billion in outstanding debts. Significant losses at investment bank Merrill Lynch due to "synthetic CDO" (which combine CDO and CDS risk characteristics) played a prominent role in its takeover by Bank of America.