An Explanation of Credit Default Swaps

By Brett Melson Monday, May 17, 2010

During the financial crisis, the government bailout of AIG focused the public’s attention on credit default swaps, an extremely large but previously ignored segment of the financial market. Despite frequently mentioning credit default swaps, politicians and pundits rarely stop to discuss what credit default swaps are, how they work and what purpose they serve. Here, we attempt to answer some of those questions.

What Is a Credit Default Swap?

A credit default swap is a privately negotiated agreement between two parties in which one party (the “protection seller”) agrees to pay the other (the “protection buyer”) a sum of money (the “notional amount”) in the event an event of default occurs with respect to an issuer of debt, such as a corporation, a pool of mortgage or other loans or a state or national government (the “issuer”). An event of default would include the issuer’s failure to pay timely interest or repay principal on debt obligations, among other possible events that the protection seller and protection buyer agree upon.

In exchange for the protection seller’s agreement to pay the notional amount upon an event of default, the protection buyer pays the protection seller a periodic fee. The amount of the fee reflects the risk that the protection seller feels it is taking on agreeing to pay the notional amount upon default; the fee, therefore, gives a rough measure of the protection seller’s belief regarding the likelihood of the issuer’s default. If an event of default does not occur upon the expiration of the swap, then the notional amount is never paid and the protection seller has gained in the amount of the fee paid over the term of the swap.

Credit default swaps generally are documented using agreements published by the International Swaps and Derivatives Association, often referred to as “ISDA.”  ISDA’s agreements provide a common and consistent set of defined terms and contractual provisions which the parties can vary to suit their needs. Starting with a common set of base agreements, which each party has used before, permits the parties to a credit default swap to avoid a great deal of confusion and negotiation that they would otherwise face in starting with a new form.

In addition, once a protection seller and a protection buyer have negotiated a credit default swap on ISDA’s agreements, they can quickly enter into additional swaps by simply using the same documents, modifying the terms only as needed to suit a particular transaction.

How Is a Credit Default Swap Used?

A credit default swap can be used to hedge risk or for speculation. When used for hedging, a credit default swap is similar to an insurance contract. A person or entity that holds the debt of an issuer may be worried that it will default and the debt will either not be repaid at all or the market value of the debt will fall precipitously. As a result, the person or entity would become a protection buyer, paying the fee to a protection seller in order to offset (or “hedge”) the risk of the issuer’s default. 

The fee paid to the protection seller will lower the debt holder’s returns if the issuer does not default, but entering into the swap will protect the holder if default occurs. Similarly, a homeowner may pay a homeowner’s insurance plan premium for years without incident, but by paying the premium the homeowner is hedging the risk of catastrophic loss.

When used for speculation, the protection buyer does not own any debt of the issuer. The credit default swap is a means by which the protection buyer can “bet” (for lack of a better term) that the issuer will default.

In the buildup to the credit crisis that began in 2008, use of credit default swaps for speculation far outweighed their use for hedging. This is evidenced by the fact that during that period it was common to find that the aggregate notional amounts that would be payable upon a given issuer’s default would equal many times the issuer’s total outstanding debt. 

In addition, the activities of protection sellers were a key contributing factor to the failure of AIG, among other entities. In the frantic market for credit default swaps leading up to 2008, protection sellers would often agree to pay notional amounts that far surpassed their assets. When a default occurred, such as the default of Lehman Brothers, the protection seller could not make the promised payment, and, without government intervention, the losses could potentially have rippled out to other financial firms reliant on such protection, causing them to also fail.

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