Kenneth R. Szulczyk
Figure 1. The Volatility Index (VIX) between 1990 and 2012
Insurance companies and investment banks created Credit Default Swaps (CDS). This
financial instrument is similar to insurance. Some investors would like to purchase speculative
grade (i.e. risky) bonds because these bonds pay greater interest rates than safe investments.
However, if the business bankrupts, then these bonds become worthless and the investors lose
their investment. Thus, CDSs were born. Investors could buy both risky bonds and CDS
contracts. Furthermore, investors would pay premiums on CDSs as if they were paying for
insurance to the investment banks or insurance companies. If a company did bankrupt and its
risky bonds collapsed in value, subsequently, the investment bank or insurance company would
pay the investors their loss specified under the CDS contract. If the company with the risky
bonds did not bankrupt, then the investment bank kept the premium payments as profits.
Subsequently, investors can buy and sell credit default swaps on the derivatives market.
CDSs have two severe drawbacks. First, CDS contracts are not transparent. Many investors
did not understand how to use CDS except the analysts at the large investment banks. Second,
investors rarely buy CDS contracts for bonds or other debt from financially strong companies
with AAA ratings. These companies are not likely to bankrupt, and investors have little reason
to purchase insurance for an unlikely event. Investors are likely to purchase insurance for
probable events. Thus, investors are likely to purchase CDSs for speculative grade bonds or
debt. Furthermore, companies rarely file for bankruptcy during good economic times, even risky
businesses that issued risky bonds. Consequently, the investment banks would collect CDS
premiums as pure profit. During good times, AAA rated companies have a zero default rate
while speculative grade bonds have a default rating less than 4%. However, during the 2001
Recession, AAA rated companies still had close to a zero default rate while the default rate
soared to 10% for speculative investments. As bankruptcies climb, companies can accumulate
staggering losses during a downturn in the economy.