Credit default swaps (CDS) intro

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Credit default swaps (CDS) intro발음듣기

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Let's say that I run some type of a pension fund, and I have $1 billion that I need to invest someplace.발음듣기

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And I dig around a little bit, and there's this Company A over here, and it needs to borrow a billion dollars, and it's willing to give 10% interest in exchange for borrowing that billion dollars.발음듣기

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So if I give these characters over here my billion dollars, if I lend it to them, if I lend them the billion dollars, on an annual basis, they're going to give me 10% interest.발음듣기

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There's a problem here though.발음듣기

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The rating agencies, the ones that in theory should be independent, they've only given Company A a BB rating.발음듣기

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And this is a pension fund.발음듣기

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I have to only invest in the safest of safest of securities.발음듣기

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I have to invest only in things that are AA.발음듣기

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And so here might enter a character like AIG, and obviously things have changed since their heyday.발음듣기

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But AIG, based on at least Moody's perspective, has a AA rating.발음듣기

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So AIG could say, hey, look pension fund, why don't you lend them the money, and what we're going to do is enter into a credit default swap.발음듣기

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And what that essentially is, is a form of insurance.발음듣기

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Of that 10% every year, why don't you give us 1% of that?발음듣기

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And in financial lingo, that's sometimes referred to as 100 basis points.발음듣기

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And in exchange for that, in exchange for that 100 basis points a year, you could view this as the insurance premium, we are going to ensure that if for whatever reason Company A defaults on that debt, you can give us the debt, you can give us that debt security, and we will just give you back your billion dollars.발음듣기

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Now from the pension's point of view, this sounds pretty good.발음듣기

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They're now getting a net 9% of interest, 10% minus the 1%.발음듣기

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And they're essentially getting to lend to a BB company, but it's in effect like lending to a AA, because as long as AIG is good for the money, then the pension fund is going to get their money back one way or the other.발음듣기

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Now where this gets a little bit shady is AIG right here didn't have to do anything.발음듣기

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What's interesting about credit default swaps - credit default swaps sometimes referred to as CDSs - is that even though they are insurance, for all purposes they are insurance, they are not regulated like insurance.발음듣기

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So typically an insurance company when they insure something, they have to set aside some money, in case that thing actually happens.발음듣기

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And they have to work out the probabilities and all of that.발음듣기

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Credit default swaps were not regulated in that way.발음듣기

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So AIG could do this without having to set aside any type of money.발음듣기

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And they could do this over and over and over and over again, kind of snowballing all of their potential liabilities.발음듣기

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And so you could imagine, it's really good money while no one is defaulting, but all of a sudden when people start defaulting, then all of a sudden AIG is going to be in trouble.발음듣기

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And all the people who thought they had, in effect, AA debt because AIG was insuring it, might not.발음듣기

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