Part 1: Credit Default Swaps

Credit Default Swaps. What are they?

From Investopedia

"A Credit Default Swap (CDS) is a financial derivative that allows an investor to swap or offset their credit risk with that of another investor.To swap the risk of default, the lender buys a CDS from another investor who agrees to reimburse them if the borrower defaults."

In English:

Think of a CDS as an insurance policy, where the buyer of the CDS would pay premiums to the seller of the CDS until the contract expires, while in the event that the borrower is unable to pay back the lump sum, the seller of the CDS will be holding the bags of liability, and they are obliged to pay the buyer of the CDS the insured secruity's value.

Analogy:

A lends $10m to B, but A thinks that B will have trouble paying that lump sum back. C steps in and offers to sell A a 2 year CDS on that loan: C offers to take on the liability of A's loan, and is obliged to pay A $10m if B defaults on the loan. But in return, A will be paying C monthly / yearly premiums until the contract expires

A: Will pay C monthly premiums, but if B defaults on loan before expiry of contract, will get insured amount of $10m from C

B: Borrower of $10m from A

C: Will receive monthly premiums from A, but if B defaults on loan before expiry of contract, obliged to pay A insured amount. Liability bag transferred from A to C.

As the risk of B defaulting goes higher, so does the price of the insurance policy...

Cue the 2008 Finanical Crisis

Bonus Resource 1: Collaterized Debt Obligations

Selling insurance on the insurance on the insurance of CDOs...

Now that we have learnt about CDS, let's dive right into CDOs. So, instead of plain old loan liabilities, the debt being packaged into the CDOs can actually be anything in the world, ranging from credit card debt, to corporate debt, and even to mortgage loans. But in this case, we would be focusing mainly on Mortgage Backed Securities (MBS), which is a type of CDO.

The CDO can be split into various tranches / risk classes, where a AAA rating would mean that it gets the highest priority for repayment by the borrower, and is thus a low risk and low yield return for the investor/buyer, while a BBB rating would usually mean that it gets the lowest priority for repayment by the borrower, and is thus a high risk and high yeild return for the investor/buyer.

Analogy:

Imagine that the bank is a real estate agent, and the bank invites you to stay in a 7-floor residential building (CDO), where the lower floors (BBB ratings) are quite prone to flooding events (mortgage loan default), in comparison to the safer upper floors (AAA ratings). Every month, the real estate agent rewards your stay with payment, which goes from the highest floor, and thus the smallest percentage return, to the lowest floor, and thus the highest percentage return.

The lower you stay, the more prone you are to the flooding events, but the more cash/interest you will earn from "investing" in this CDO.

In this case, from the CDS analogy, the bank is person A, while your average joe is person C: In the case of the borrower defaulting, person C will be taking on the liabilities, not person A.

But hey, what are the chances of that happening, right? Surely the banks would be responsible when it comes to lending out money, right?

:D

Since the banks are passing on the liability bags to the investors instead through the sale of these CDOs, banks are incentivized to dish out loans to even those who do not have a proper credit rating.

What do they stand to lose? Nothing! They aren't the ones who are left holding the bags. What do they stand to gain? The more CDOs they sell, the more money they earn from the investors. Other than that, due to internal competition between rating agencies, the CDO tranch ratings were typically overstated: that is, a "BBB" rating would be sold as a "A" rating to the banks, which would then be sold to retail investors.

Bonus Resource 2: The tragedy of Howie Hubler

TL;DR: He made a correct bet and shorted the risky subprime mortgages in the US: he bought $2 billion in CDS (debt insurance) on extremely riskly mortgages, which will rise in price once the defaults started to kick in.

But to fund that $2 billion, he made a mistake and sold $16 billion worth of CDOs which he deemed to be safe. Essentially, he became the insurance agency and held $16 billion worth of liability (debt) bags, because he believed that only the "BBB" ratings would be affected, and the cataclysm would not be felt by the "AAA" ratings.

In essence, he anticipated a flood and not a tsunami.