Money, Banking, and International FinanceInvestors trade CDSs contracts in the derivatives markets. Anyone can buy them, even if the
investors do not own the risky bonds that are specified under the CDS contract. Therefore,
speculators can enter the market and gamble on outcomes. For example, gamblers believe
Company XYZ will bankrupt. These gamblers do not hold any bonds for this company, but they
buy CDS contracts. Gamblers only pay the CDS premiums. However, if this company does
indeed bankrupt, then the gamblers receive a payout from the issuer of the CDS contract. If
Company XYZ does not bankrupt, subsequently, the gamblers lose their bet, the CDS
premiums. Imagine the money people could earn if they had inside information about a
company’s finances.
Some investors bet the housing market would collapse and bought CDS contracts on risky
mortgage pools. Investors bought CDS contracts on mortgage asset-backed securities because
they predicted the collapse of the housing bubble in 2007 and purchased CDS contracts as a bet.
As the mortgage asset-back funds bankrupted, the holders of CDS contracts requested their
payouts. If you are experiencing trouble understanding CDS contracts, then think of this
analogy. You bought insurance on your neighbor’s house, and you pray for the house to burn
down to collect the insurance.
The CDS contracts have a flaw. A company can stack CDS contracts upon other CDS
contracts. For example, Company X buys a CDS contract from an insurance company and pays
2% of the contract’s value as a premium. Unfortunately, the financial health of the company,
specified in the CDS contract, deteriorates, increasing the risk on its bonds. Company X can
exploit this situation, and create and sell a new CDS contract to Company Y for a 6% premium,
earning 4% commission on the deal. If that company does bankrupt, then the insurance company
pays Company X its CDS insurance, and in turn, Company X transfers its payout to Company
Y, earning a quick 4% commission on the deal. Thus, multiple CDS contracts insure the same
debt. Unfortunately, the CDS contracts depend on one important assumption. Issuing companies
can indeed pay out the CDS contracts if the companies fail.
The CDS market in the United States quickly grew into $47 trillion market by June 2008,
covering a debt of roughly $34 trillion. Putting this number into perspective, the size of the U.S.
economy was roughly $14 trillion in Gross Domestic Product (GDP) in 2012. Consequently, the
potential losses if the investment banks and insurance companies must pay out all CDS contracts
would exceed three times the size of the U.S. economy. Commercial and investment bankers
used CDS contracts to guarantee an AAA rating for Collateralized Debt Obligations, which
contained securities tied to the mortgage market. They used the CDS contracts to cancel the
impact of subprime mortgages contained in the mortgage securities. We had discussed the
Collateralized Debt Obligations in Chapter 10 under Securitization.
During the downturn of the U.S. economy in December 2007, AIG quickly accumulated
billions in losses as investors requested the payouts from the CDS contracts. AIG’s losses
exceeded $60 billion in 2009 and grew by the day. This became the largest loss in U.S.
corporate history. The U.S. federal government bailed out AIG by purchasing 80% equity into
the company. Furthermore, it promised AIG four bailout loans worth a total of $163 billion.
Unfortunately, AIG worked with several investment banks like Goldman Sachs and Lehman
Brothers, which also experienced severe financial troubles.