What are credit default swaps?

The Credit Default Swap Situation
Treasury Secretary Henry Paulson (left) and Federal Bank Chairman Ben Bernanke testify to Congress about the 2008 financial crisis.
Treasury Secretary Henry Paulson (left) and Federal Bank Chairman Ben Bernanke testify to Congress about the 2008 financial crisis.
Ryan Kelly/Congressional Quarterly/Getty Images

If the subprime securities market crisis that stalled the U.S. economy in 2008 was a threat, the CDS market posed a potential death sentence. Enormous, seemingly untouchable financial institutions, heavily invested in mortgage-backed securities, began to crumble. And many of these failing institutions owned credit default swaps on their subprime securities. Swaps that didn't pay out forced institutions to lower their asset values, causing them to fail even further, freezing the exchange of money (the so-called credit crunch) and, by extension, the entire economy.

What sets the mortgage crisis apart from any potential CDS crisis is that if you follow a mortgage far enough down the line, you eventually come to a house. If a borrower defaults on a loan, the bank can still recoup some of its money by taking possession of the house and selling it. This isn't the case with CDSs; they're based on an action (like a bank failing), not a thing (like a house). And because of their intangible nature, finding a source of capital to cover CDS payouts is less exact. Even more difficult than getting blood from a stone is getting money from thin air.

And the potential losses from the credit default swaps market dwarf those seen from losses associated with subprime mortgage-backed securities. In 2007, the global credit default swaps market was valued at $62 trillion [source: ISDA]. The U.S. mortgage securities market had a value of about $7 trillion [source: New York Times].

To put the CDS situation into even further perspective, the gross domestic product (GDP) of the United States in 2007 -- the total value of all the goods and services generated in the country that year -- was $13.84 trillion [source: CIA]. In the third quarter of that same year, the top 25 banks in the United States held $14 trillion in credit default swaps [source: New York Times]. ­ So even if the United States could liquidate its entire GDP for the year at once, it still wouldn't cover U.S. CDS losses should a series of credit events -- those triggers for CDS payouts -- occur.

A clear picture of the precarious state of the economy balanced on the CDS market was drawn in 2008. In September, insurance giant AIG was saved from collapse by an $85 billion infusion of government cash. The bailout also saved those holding the bag on credit default swaps on the company's bonds; a credit event was averted by government intervention. This wasn't the case when mortgage holding corporations Fannie Mae and Freddie Mac were taken over by the federal government that same month. The action was considered a credit event; investors holding CDSs on bonds (shares) in the two corporations were eligible to submit claims on their policies.

Between the two, Mae and Mac have issued $1.5 billion in bonds to generate capital [source: SMH]. It's hard to tell what the total value of the CDSs taken out on this debt amounts to, but it's most likely much more than the $1.5 billion in actual bonds. Just as a life insurance policy can pay out much more than the deceased party's annual salary, so too can credit default swaps be structured to cover more than the actual losses.

Ironically, the government action may have actually averted widespread CDS claims filed on bonds issued by the mortgage giants; government intervention actually caused the corporation's values to rise slightly. The precarious balance was maintained. For how long, such a disaster could be averted -- or even if it could be -- no one could say.

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