I wonder what Adam Smith would say regarding Credit Default Swaps?
A Credit Default Swap (CDS), on the surface, appears to be a reasonable financial instrument, as it essentially represents insurance on bonds. Think of it like this: an investor purchases bonds issued by Acme Corp., with the expectation to receive periodic payments, every six months.
However, there is a likelihood that Acme Corp. may go bankrupt and default on those bonds. This may represent a minimal risk; still, if it occurs, the investor no longer receives the regular payments. Therefore, the investor may opt to purchase a CDS as a kind of insurance policy.
If Acme Corp. does not go bankrupt, the investor absorbs the expense of the CDS, or the premium on its insurance. Or, should Acme Corp. enter bankruptcy proceedings, the investor receives a payout, based on the terms of the CDS.
This seems like a responsible practice for managing risk, an evolutionary extrapolation of the process of lending money to finance growth and one in which I am sure Mr. Smith would endorse, at least conceptually. In fact, historically, as bond issuers rarely go bankrupt, it would seem a natural market development.
But, let’s say it becomes increasingly difficult to earn a return on traditional investment vehicles. So, rather than specialize on trading bonds, with their minimal rates of return, more and more entities start to sell CDS instruments.
The risk, at least historically, seems low, there is no up-front cash outlay, and you only have to pay out if the issuer defaults, which they rarely do. Besides, you can always borrow to pay down your obligations, right? This is why, beginning in the 1990s, banks and hedge funds began to more aggressively buy and sell CDS contracts, as opposed to the actual bonds. By the end of 2007, the market for CDS contracts had grown to hundreds of trillions of dollars globally.
Unfortunately, many of these CDS contracts were essentially insurance on exotic, complex financial instruments that powered a massive build-up in subprime lending. As those mortgage-backed securities and collateralized debt obligations imploded—as they were basically bundles of bad loans that should never have been extended in the first place—the banks and hedge funds were faced with the grim prospects of honoring those CDS contracts.
As most banks bought and sold CDS contracts, a default would not produce a net change. They paid out on defaults, but also collected. There were some, though, who only sold CDS contracts.
AIG was one such financial institution. It sold $440 billion in CDS contracts. Subsequently, it required a massive $85 billion federal bail to rescue AIG, as the subprime mortgage and banking crisis plunged the global economy into a deep recession.