Credit Default Swap

Could a knowledgeable individual please explain Credit Default Swaps on a broad level? I'm a bit confused about who sold them, how they work, who gets paid in the event of bankruptcy, and what exactly happened with all the CDSs that Lehman I guess created and sold? Thanks.

Best Response

CS, I'll do my best to keep this simple, as it's convoluted as hell. A CDS is a type of derivative called a swap. They trade OTC and can be anything from privately traded and extremely hand tailored to the two parties or standardized for ease of use. The swap essentially trades one cash flow for another. Two parties enter into a contract to exchange cash flows at a later date in time for some agreed upon value. While there are a number of different types of swaps, the easiest to explain this with is an FX Forward contract, where you sell one currency and buy another at both a time and price agreed upon by the the two parties involved in the swap. What typically happens is that one party will take a short position by selling the currency now and, at a future date in time, close the short out with a long FX forward contract, creating an exchange of cash flows. Profit, in this case, is made when the value of the currency less the value of the forward is positive.

Credit Default Swaps take this concept and instead of using something like an interest rate or FX, they swap cash flows on credit. These contracts are traded privately and are extremely tailored to the two parties. Basically what happens here is the Buyer will pay the seller a premium to provide protection in the event that a bond defaults. If the bond defaults, protection (Payout) is provided in one of two ways. The first is physical settlement, where the buyer delivers the defaulted asset to the seller for a payment of par value on the CDS. The second is cash settlement, where the seller pays the buyer the difference between par and the market value on the bond. Par Value, by the way, is the notational value for the CDS. It's similar to a bond, except it tends to reflect the total size of the position instead of the face value on 1 note.

Here's your basic swap in action:

Say Hedge Fund X (HFX) owns $10 million worth of a five-year bond issued by someone with a risky credit rating, such as The State of New Jersey. IF HFX feels that NJ may default on its loans, they will buy a CDS from a counterparty, typically a bank. HFX buys the CDS at a notational (Par Value) value equal to the bonds it has with a 5 year duration from a seller such as, in this case, Goldman Sachs. According to the terms of the Swap, HFX will pay Goldman some total yearly premium on an installment base in return for the protection. In our story, HFX pays 1% of the Notational each year to Goldman in Quarterly payments. Now, over the course of the 5 years, NJ can either not default or default. IF NJ does not default, HFX will have paid Goldman a cool 500,000 for the premium on protection and receives 10 Million from NJ as repayment of the bonds. In this case, you make less on returns owning the CDS, but you have elimited your downside risk of default. IF Jersey defaults, HFX Stops paying the premium and settles up with Goldman by one of the two ways above. This is the most basic view of a CDS and doesn't get into reselling or spec. on a CDS, but you get the idea.

I'll fill this in with more color later, as there is some stuff regarding the Lehman bankruptcy that I need to check sources on to see if it's not REG FD'd by my firm. I suspect its not, but I want to make sure of it. However, from what I do recall and what happens to have been published, whoever held the Lehman CDS with their bonds could deliver the bonds to the seller for a full return on the notational of the swap, which I doubt will happen, or they could say pay me the difference between the notational and the recovery (the price the bond is valued at during default). The CDS Swaps were valued at 8 and 5/8 cents on the dollar, so the seller needs to pay out a cash settlement of 91 and 3/8 to whomever settles in cash. Right now, people are just starting to redeem them all.

I got this question in a recent interview w/ Citi -- I was talking about how I had learned what a CDS was this past summer and then my interviewer asked me to briefly explain what it was. After I did so (it's a hedging instrument), he asked me why I couldn't use a put option..... can anyone answer that for me?

I'm pretty sure a CDS doesn't require any capital up front, so it gives you a leveraged position (whereas you pay the premium up front when buying an option)

sooo... in one sentence? CDS are insurance against default.

If you think about it though, perfect insurance would negate your returns so there would be no reason to buy the bond in the first place. The way that CDSs were utilized in the buildup to the subprime meltdown was as straight shorts. The example above is very good, but now imagine Hedge Fund Y doesn't like the state of NJ's books either. Instead of lending New Jersey money though, they simply call up Lehman and purchase a CDS against a bond they never even owned. Now, if NJ defaults on their debt, Lehman has to pay to cover the CDS they issued HFY and HFX. As NJ's credit deteriorates, the value of the CDS rises and the value of the bond falls, so buying both is a classic hedge while buying one is a straight-forward bet. The issue with this is that the liabilities from NJ going bankrupt now exceed the amount of money lent to NJ, making the effect of its default greater than its net liabilities; AIG and others got in trouble for this reason, because they issued CDSs without much regard to credit risk or how many times they were insuring the same bond. That's my basic understanding; Michael Lewis wrote a very good piece a little while ago on the issue:…

Why not pick a topic that has people with firsthand knowledge in your immediate vicinity? Not many CDS traders in Michigan.

Also, from my perspective the prospect of being interviewed by a college kid isn't particularly exciting for most on here so you likely won't get a lot of hits, and the pool of people with direct experience in CDS is small.

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