Credit Default Swaps: They're Still Here and Still Dangerous


Run for your lives. They're back. Though it's more accurate to say they never left.

I'm talking about credit default swaps, those things with the funny name so prominent in the news as the U.S. economy came to a crashing halt in 2008. With the looming, potential default of Greece on its sovereign debt, credit default swaps are suddenly back in the headlines. Here's a short course on exactly what they are and why they still pose a threat to you and me.

A vague recollection
Long before I was an investment columnist, I remember hearing about these things called "derivatives." I have a vague recollection of dire warnings delivered by politicians and the media about the dangers derivatives posed to the economy. I didn't understand exactly what derivatives were, but got the general notion they were very complicated ways of investing money that only Wall Street types really understood.

As it happened, my vague recollection and general notion turned out to be largely correct. A derivative is a contract between two parties specifying the conditions under which payments to each other are to be made. A credit default swap is a type of derivative, one used to protect against the default of a "debt instrument," i.e., a bond or security. Just as with an insurance policy that insures you against a house fire, with a credit default swap you pay a premium and are insured against a defaulting debt instrument.

Wall Street dreamed up credit default swaps in the late '90s. They became very popular, very fast. In 2000, the market was $900 billion. By 2008, it was more than $30 trillion. Who used them? Banks, investment banks, hedge funds, and an insurance company called American International Group (NYS: AIG) .

I'll bet your house burns down
Those three letters -- AIG -- probably ring a very loud bell. AIG got mixed up in the swaps market as it was changing. Instead of using credit default swaps to insure their investments, people were using them to speculate on assets they didn't own. Going back to the house analogy, it was like buying fire insurance on your neighbor's house. If the house never burned down, you were out your premium, but if it did burn down you'd collect a big payout. So credit default swaps quickly moved from being a way to insure yourself to a way to place a bet. AIG was the company on the hook for making a lot of these payouts should they ever come due.

The problem was, swaps were often made privately instead of through a centralized clearinghouse, so as they were being entered into in extraordinarily large numbers, there was no way to know who owed what to whom. When the subprime mortgage-backed securities that fueled America's housing bubble began to default, a sizeable portion of that $30 trillion swaps market started coming due.

Companies suddenly found themselves overexposed. When Lehman Brothers went bankrupt as a result of overleveraged investments in bad investments, the federal government had to bail out AIG. Merrill Lynch was going down fast and was saved only with a last-minute purchase by Bank of America (NYS: BAC) , which was itself bailed out. Goldman Sachs (NYS: GS) and Morgan Stanley (NYS: MS) would have gone under, too, had the federal government not backstopped them. JPMorgan Chase (NYS: JPM) did for Bear Stearns what Bank of America did for Merrill Lynch before receiving its bailout.

Thank you very little, Dodd-Frank
In the wake of the crisis, the need for a clearinghouse was obvious, and there is one today, sort of. Wall Street-owned Depository Trust and Clearing Corporation claims knowledge of 90% of credit derivatives-market transactions and releases aggregate data on a weekly basis. It's better than nothing, but it doesn't provide near the transparency available as, say, the New York Stock Exchange. The Dodd-Frank financial-reform bill of 2010 was supposed to require all standardized swaps to appear on exchanges and run through clearinghouses. But Wall Street is still haggling over the exact rules, and the Commodity Futures Trading Commission, which is primarily responsible for setting them, is woefully underfunded.

So here we are. Credit default swaps are back in the news because of Greece. After one bailout to avoid a debt default, the country is on the verge of a second, with $70 billion in credit default swaps at stake. This week, the International Swaps and Derivatives Association ruled that this debt restructuring was not sufficient to trigger the relevant credit default swaps if the vast majority of lenders agree to it, but it ominously added that the swaps could be triggered sometime in the future.

I dream of rebottled genie
The swaps market is currently estimated to be about $36 trillion. Given the havoc they wreaked, you might have thought -- reasonably so -- that using credit default swaps for purposes other than insurance would have been abolished. But it's always hard to get the genie back in the bottle once he's out, especially when said genies are so profitable, and the institutions that release them don't have to answer for the horrors caused.

So here we are, more than three years after the start of the worst financial crisis since the Great Depression, in which credit default swaps played a starring role, still staring down the barrel of the swaps cannon. Yes, the market is a little more transparent now, but not transparent enough, and there is a lot of swaps exposure floating around out there waiting to be triggered.

Credit default swaps are about as opaque an investment as you can get, and the big Wall Street banks aren't much better. In that spirit, here's a delightfully straightforward investment The Motley Fool is calling its top stock for 2012. Read all about it in our special free report, aptly titled "The Motley Fool's Top Stock for 2012." Get it while the stock is still hot.

At the time thisarticle was published Fool contributorJohn Grgurichis currently in the middle of a real cliffhanger swap, involving some 1975 Topps baseball cards, but he own no shares of any of the companies mentioned in this column. Follow John's dispatches from the bloody front lines of capitalism onTwitter, @TMFGrgurich. The Motley Fool owns shares of Bank of America and JPMorgan Chase. Motley Fool newsletter services have recommended buying shares of Goldman Sachs. Try any of our Foolish newsletter servicesfree for 30 days. We Fools don't all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has a perfectly scintillatingdisclosure policy.

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