Credit Default Swaps: ‘Financial WMDs’

We are all painfully aware of what is happening on Wall Street. In fact, I think that it might take several years for the stock market to regain the value that it has lost in the past year (approximately 35 percent).

No doubt, there is plenty of blame to go around as to who is primarily responsible for this financial debacle. However, most experts agree that a prime candidate for blame is the credit default swap.

Credit Default Swaps Explained

Michael Greenberger, a former staff member of the Commodity Futures Trading Commission, describes a credit swap as follows: “A credit default swap is a contract between two people, one of whom is giving insurance to the other that he will be paid in the event that a financial institution, or a financial instrument, fails. It is an insurance contract, but they’ve been very careful not to call it that because if it were insurance, it would be regulated. So they use a magic substitute word called a ‘swap,’ which by virtue of federal law is deregulated.”

A credit default swap is an investment instrument that is a so-called derivative security. This term simply means that the value of a derivative derives from an underlying (but not always visible) asset. Examples of such assets would be stocks and bonds. Another example — and this might come as a surprise — is the insurance policy on your house. The policy itself is a derivative asset. Even your life insurance policy can be regarded as a derivative. In fact, if you are elderly or in poor health, you can sell your life insurance contract (see my article on life insurance settlements).

How did derivatives gain such a bad reputation?

A Short History of Derivatives

This type of investment has been around for many years. In fact, six years ago we had approximately $106 trillion in derivatives. Today, we have an amazing $531 trillion. The billionaire and investor Warren Buffet has called this type of investment “financial weapons of mass destruction.”

With over $500 trillion now invested in derivatives, you can see the potential for disaster if something happened to this market. Well, actually, something is happening to this market. Simply put, it’s been crashing.

The types of derivatives that are losing so much of their value are the exotic pools of mortgages that have been sold to banks, investment banks and institutional investors. What happened is that a bunch of smart MBAs convinced investment banks that they found a way to “slice and dice” pools of mortgages thereby creating a wide array of financial instruments that would appeal to a broad group of investors.

The Creation of an Exotic Pool of Mortgages

Let’s say that a mortgage bank has lent $500 million to various homeowners. Within the $500 million are some good loans and some bad loans. The bad mortgage loans would be those that were lent to borrowers who had poor credit and/or very little equity in their homes. These are the so-called toxic assets.

The mortgage bank would then go to an investment bank to sell the entire loan pool or loan package. The investment bank would then split the original pool into various parts, also called “tranches.” The individual tranches would each be unique in that some would offer a high rate of return with a greater degree of risk, while others would offer a lower rate of return with less risk.

The trick for the smart MBAs would be to make even the higher-risk loan packages look attractive. They did this by creating a credit-default swap for these loans. What this means is that basically a third party would guarantee the pool if some of its loans began to turn sour. The guarantee, the credit default swap, is basically an insurance policy, thus a derivative security.

The Inherent Danger in Credit Default Swaps

It seems perfectly logical and prudent for an investor to buy a mortgage pool that is “insured.” The problem is that the insurers, in some instances, were writing so much insurance on so many bad mortgages that if the eventuality ever occurred — and it did — that massive pools of mortgage would become toxic, or in the words of Warren Buffet become financial weapons of mass destruction, then the very insurance company that wrote the credit default swap would be in danger of collapsing. This, in fact, is what happened with AIG.

Thus, investors that buy pools of mortgages became less diligent in verifying the soundness of their pools and thus were lulled into a disaster. They stopped checking the soundness of the pools and just assumed that, in the event that the housing market collapsed, they would be made whole by the insurance company since the pool that they bought had a credit default swap.

The Trading of Credit Default Swaps

What makes this situation even more convoluted is that investors that had pools of mortgages with credit default swaps could actually increase their yield on their investment if they sold their credit default swaps as a separate financial instrument. Remember, a life insurance policy can be bought by an individual seeking protection for his/her family and later can be sold by that individual as a separate instrument, resulting in the loss of protection to the buyer’s estate.

Investment banks and other investors thus sold the protection that they originally bargained for as part of the purchase of a pool of mortgages, thus exposing them to the risk of owning an uninsured pool. The rest is history.

A Silver Lining

There is a silver lining to this sad tale. That is, governments throughout the world have decided that it is in their national interest to prop up faltering banks that have made less than sound investment decisions. While this doesn’t undo all of the bad that these “investments of mass destruction” have caused, it does, to some extent, mitigate the losses on these investments.

Good luck!

Theodore F. di Stefano is a founder and managing partner at Capital Source Partners, which provides a wide range of investment banking services to the small and medium-sized business. He is also a frequent speaker to business groups on financial and corporate governance matters. He can be contacted at [email protected].

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