Photo from YouTube
In an iconic scene in “The Big Short,” a 2015 film about The Great Recession of 2008, Dr. Michael Burry (Christian Bale) pitched the creation of credit default swaps (CDS) to allow him to bet against mortgage-backed securities in the U.S. housing market. His proposal was based on his analysis that the U.S. housing market would collapse in the second quarter of 2007. Seeing this as an opportunity to gain profits, the bankers sold a total of USD 100 million in CDS to Burry.
By now, you might be wondering, what exactly is a credit default swap?
To best answer that question, it’s important to first know how the financial tool was created.
Necessity is The Mother of Invention
In 1994, J.P. Morgan, a financial institution, was caught between a rock and a hard place when one of its largest clients, Exxonmobil Corporation, a large oil company, asked for a huge credit line despite possessing large amounts of capital. This was because one of its tankers was involved in an oil spill, leading to the possibility of punitive damages due to the accident.
Photo from YouTube
While it would have been easy to reject Exxon’s request, J.P. Morgan was worried that doing so would burn its entire relationship with the oil firm and cost it dearly in the long run. On the other hand, the financial institution couldn’t ignore the financial risk associated with its client at the time.
Instead of settling with these difficult choices, a group of J.P. Morgan bankers decided to sell the risk of a default instead of having the institution carry the financial burden.
In the scheme that the bankers created, J.P. Morgan would lend to Exxon, and then pay a number of counterparties a set amount each year. If the oil company couldn’t pay its debt, these third parties would pay the financial institution—effectively mitigating the risk of default.
Once the specifics were ironed out, J.P. Morgan was able to use the first CDS to hedge against the risks associated with extending its credit to Exxon.
Even though 29 years have passed, a CDS still works the same way as it did when J.P. Morgan first used it, but only with a few differences.
Nowadays, a CDS is a financial derivative that allows an investor, company, bank, or any other entity to mitigate credit risk.
In this type of financial contract, when a buyer agrees to purchase a CDS from a seller, he or she will make premium payments to the latter until the credit reaches maturity. Should the debt issuer default on obligations, the seller will pay the buyer all the premiums and accrued interest.
As you can see, this financial derivative is a great way for investors and other entities to protect themselves from the dangers of a potential default. Moreover, CDS is a useful tool for liquidity since it enables the transfer of risk from one party to another.
During its early years, CDS was used primarily as a hedge against defaults, making it an important aspect of any risk management strategy. However, as this financial instrument grew in popularity and became standardized, it also became a way for investors and credit rating agencies to speculate on the creditworthiness of companies.