Credit default swaps 2 | Finance & Capital Markets | Khan Academy

Credit default swaps 2 | Finance & Capital Markets | Khan Academy

January 5, 2020 100 By Kody Olson


So let’s see if we can get a
big picture of everything that’s happening in this credit
default swap market. I’ll speak in generalities. Let’s say we have Corporation
A, Corporation B, Corporation C. And let’s say we have a bunch of
people who write the credit default swaps, and I’ll
call them insurers. Because that’s essentially what
a credit default swap is, it’s insurance on debt. If someone doesn’t pay the
debt, then the insurance company will pay it for you. In exchange, you’re essentially
giving some of the interest on the debt. So let’s say we have Insurer
1, let’s say we have Insurer 2. And some of these were insurance
companies, some of these were banks. Some of these may have even
been hedge funds. So these are the people who
write the credit default swaps, and then there are the
people who would actually buy the credit default swaps. In the previous example, I had
Pension Fund 1, that was my pension fund. Then you could have another
pension fund, Pension Fund 2. Let’s re-draw some of the
connections between the organizations. Let’s say Pension Fund 1 were
to lend $1 billion to A. A will pay Pension Fund 1 10%. But Pension Fund 1 wants to
make sure that they’ll definitely get the money,
because they can’t lend money to people with anything less
than stellar credit ratings. So they get some insurance
from Insurer 1. So what they do is out of this
10%, they pay them some of the basis points. So let’s say they pay them
100 basis points. And in exchange, they get– I’ll
call it Insurance On A. This is this new notation
that I’m creating. They get Insurance On A. Fair enough. And the reason why this I1, this
first insurer was able to do that is because Moody’s
has given them a very high credit rating. And so when they insure
something, you’re essentially the total package, right? The loan to this guy, plus the
insurance, kind of is like you’re lending the money to
this guy, but you’re just getting more insurance– I
mean you’re getting more interest, right? So this bond becomes
a Double A bond. Because the odds that you are
not going to get your money are not the odds that this guy
defaults, but it’s now the odds that this guy defaults. And Moody’s or the standard is
poor, as I’ve already said. Hey, these guys are good for
their money, they’re Double A or whatever. So now your risk is really a
Double A risk and not a Double B risk, or whatever. But anyway, this happens. This is Corporation B, and maybe
Pension Fund 2 wants to lend to Corporation B. Maybe they lend them
$2 billion. They get, I don’t know, they get
12%, maybe Corporation B is a little bit more
dangerous. But once again, they go
to this first insurer. And maybe they get some of it–
well let’s just say they get Insurance On B. And B is a little bit riskier,
so they have to pay 200 basis points. 200 basis points goes from
Pension Fund 2 to B. Now this, already, this is a
little bit dangerous, right? Because you can think about
what’s happening. One, as long as this insurer
does not get a downgrade from their credit ratings from S&P
or Moody’s or whoever, they can just keep it issuing
this insurance. There’s no limit for how much
insurance they can issue. There’s no law that says, you
know what, if you insure a billion dollars of debt,
you have to put a billion dollars aside. So that if that debt defaults,
you definitely have that billion dollars there. Or if you insure 2 billion here,
you don’t have to put that 2 billion aside. What you have is a bunch of
people who statistically say, oh, you know, what’s the
probability that all of this debt defaults? So I just have to keep enough
capital so that probabilistically, whatever debt
defaults, I can pay it. But you don’t keep enough
capital to pay all of the defaulting debt. So you already see an
interesting risk forming. What if all of these
corporations, for whatever reason, do start defaulting
simultaneously? Then all of a sudden this
insurance company has to pay more out in insurance then it
might even have. So you have to wonder whether it even
deserves this Double A rating, because it actually is taking
on a lot of risk. But in the short term, while
these companies are– everyone is doing well and the economy’s
doing well, it’s a great business for these guys. These guys are just collecting
premiums essentially on the insurance, without having
to pay out anything. Now let’s add another
twist on it. These pension funds, P1 and P2,
it was reasonable for them to get insurance, because they
were giving out these loans and then they got
the insurance. So they were essentially hedging
the default risk by buying these credit default
swaps, which was essentially just an insurance policy
from this Insurer 1. But you can have
another party. This is no less legitimate,
really. But you could call them– I
don’t know– let’s call it Hedge Fund 1. And they’ve done a lot of work,
and frankly, they often are much more sophisticated
than the pension fund– in fact, they almost always are. And they say, you know what? Company B looks really, really,
really, really shady. I think 200 basis points for
the chance that Company B defaults is frankly cheap. Because I think there’s
a huge probability that Company B defaults. So what I’m going to do, I’m
not going to lend Company B money, because if anything, I
think that they’re maybe about to go out of business. But what I can do is I can buy
a credit default swap on Company B’s debt. Which is, essentially, I’m
getting insurance that they fail without actually
lending the money. So let’s say I do that
from Insurer 2. So I can go and I’ll pay Insurer
2 200 basis points a year, or 2% on the notional
value of the insurance I’m getting. So let’s say it’s 200 basis
points, and let’s say that’s Insurance On– I’m making a big
bet– so they’re going to give me Insurance On B for–
I don’t know– $10 billion. And something interesting is
going on here already. B might not have even borrowed
$10 billion, right? So all of a sudden you have
this hedge fund that is getting insurance on more
debt than B has even borrowed money on, right? And it’s essentially, you just
kind of have this side bet between these two parties. This party says,
you know what? I think it’s a good deal. I get 200 basis points on the 10
billion every year, as long as B doesn’t default. And this guy says, I think
B’s going to default. So I think that’s a good
deal on that insurance. And just so you understand the
math, so the notional value is $10 billion. So what’s 2% of 10 billion? 2% on a billion is 20 million,
so it’s $200 million. 200 if I did my math correct. So they’ll pay $200 million
a year to this insurer. So the 200 basis points
on 10 billion is equal to 200 million. These numbers maybe are a little
bit on the big side, but who knows? Actually, this could be
a huge hedge fund. This could be a $10 billion
hedge fund. Or even worse, maybe it’s a
billion dollar hedge fund, or maybe it’s a $20 million hedge
fund, but they’ve taken a $180 million loan to essentially
buy this insurance because they think that B’s collapse
is imminent. So they’re willing to take
that bet right now. You know, it might
be a good bet. If B collapses tomorrow,
what’s going to happen? They only dished out maybe 200
million for maybe that first year, although you normally pay
it on a quarterly basis. So they’ll pay 50 million
every three months. Let’s say they pay the first
payment, 50 million, right? And then over the next three
months, B just goes bankrupt and people realize that debt
was worth nothing. Then these guys get
$10 billion. Right? But something else is
interesting here. They probably did insurance to
a lot of other people too, maybe on B’s debt. Right? Or maybe they also
insured A’s debt. So maybe they gave
some insurance on A’s debt, as well. So what happens? Let’s say B all of a
sudden defaults. So a couple of things happen. I1 is going to owe P2
$2 billion, right? I2, the second insurer, is going
to owe this hedge fund $10 billion. Now let’s just assume I2’s
good for the money. They have $10 billion they
pay to this hedge fund. This hedge fund is great, they
get great bonuses for the year and they go buy yachts,
et cetera. But this insurer right here,
they pay the money they were good for but something
interesting might happen. All of a sudden Moody’s finally
wakes up, these ratings agencies, and
says, oh, my God. Well, there’s a couple of things
that might make them say, oh, my God. First of all, they might
say, oh, look. You have to pay out
$10 billion. And I doubt that was the only
person you have to pay, maybe they have to pay out
a lot of money. Now I2, Insurance Company 2,
you are undercapitalized. I am now going to downgrade
your rating. So, you were Double A, but since
you had to give out all of this capital, Moody’s is now
going to downgrade you to, I don’t know, B+. I’m just making these
ratings up. But that’s the sound of how
these ratings happen, right. A is better, B is worse. The more A’s you have,
the better it is. But all of a sudden, when this
guy is B+, and this guy insured, let’s say, some other
corporation’s debt for this pension fund, now all of a
sudden this insurance that this pension fund had is no
longer Double A Insurance. It’s now B+ Insurance, and maybe
this pension fund, by its charter, can’t hold
something that has a B+ credit rating. So they’re going to have to
unwind the transaction, or maybe they’ll have to unload
the debt that was insured. So one, just by Company B
defaulting, maybe this guy was holding some of Company A’s
debt, and it was insured by Insurance Company 1. Now they’re going to have
to unload that debt. So just one default creates this
chain reaction, right? This one default happens, this
guy has to pay this guy money, then this guy gets
undercapitalized since they have to pay out money. Then Moody’s says, oh, my God,
you’re undercapitalized. We’re going to reduce
your ratings. Maybe this guy was insuring
some of A’s debt, but now since he was insuring some of
A’s debt, all of a sudden that insurance is worth less because
it has a lower rating. And now A’s debt, less people
want to hold it, because there are less people to insure it. I know that’s very confusing,
but this is really the point that Warren Buffett was saying
when he said that the credit defaults swap market, or in
general, the derivative market, are financial weapons
of mass destruction. Because you have so many people
who didn’t have to set aside a capital, right? This guy could insure $10
billion worth of debt without having to set aside
$10 billion. And you have so many people
making all of these side bets, but they’re all making
two core assumptions. One, that these rating
agencies’s ratings are valid. And two, that the other person
is good for the money. But if all of a sudden you have
one failure someplace in the system, you could have
this cascade where one, there’s just a lot
of downgrades. And then a lot of the people
end up not being good for the money.