Credit Default Swaps (CDS)

A Credit Default Swap (also known as a CDS) is a financial derivative that functions much like an insurance policy. Instead of insuring your house against a fire, however, it insures an investor against a company or government defaulting on its debt. The buyer of the CDS makes regular payments, known as a premium, to a seller. In return, if the entity whose debt is “insured” suffers a credit event—such as filing for bankruptcy or failing to make a payment on its bonds—the seller is obligated to pay the buyer the face value of that debt, making the buyer whole. While these instruments can be used for legitimate protection, their history is deeply controversial, as they were a key villain in the story of the 2008 Financial Crisis. CDSs are complex contracts, almost exclusively traded between large financial institutions and are not a tool for the everyday value investor.

Imagine you are an investor named Prudence. You've just bought a $1 million bond from “We-Might-Default Inc.” because it pays a very attractive interest rate. However, the company's name makes you nervous. To sleep better at night, you decide to buy protection. You go to a large investment bank, “Goliath Bank,” and buy a CDS on your bond.

• You (the protection buyer) agree to pay Goliath Bank a premium, let's say $20,000 per year.
• Goliath Bank (the protection seller) agrees that if We-Might-Default Inc. defaults on its bond, the bank will pay you the full $1 million.

Two outcomes are possible:

1. Scenario 1: No Default. We-Might-Default Inc. stays in business and pays its debt. You continue to collect your high interest from the bond and pay the annual $20,000 premium to Goliath Bank. The bank happily pockets the premium as pure profit.
2. Scenario 2: Default! We-Might-Default Inc. goes bankrupt. Your $1 million bond is now nearly worthless. But because you have the CDS, Goliath Bank must pay you the full $1 million. You've lost your premium payments, but you've been saved from a catastrophic loss on the bond itself.

There are two main reasons someone would buy a CDS:

• Hedging: This is what Prudence did in our example. She owned the underlying asset (the bond) and bought the CDS to eliminate her risk. This is a legitimate, if expensive, form of financial insurance.
• Speculation: Now imagine a speculator named Sam. Sam does not own any bonds from We-Might-Default Inc. He simply believes the company is doomed. He can buy a CDS from Goliath Bank, betting on the company's failure. If he's right and the company defaults, the bank has to pay him $1 million, giving him a massive profit on his premium payments. This is known as a “naked” CDS, as it's a pure bet unattached to any underlying investment.

Why would Goliath Bank take the other side of this bet? To earn income. The bank has analysts who believe We-Might-Default Inc. is much stronger than its name suggests. They believe the risk of default is low, so they are happy to “sell insurance” and collect the steady, predictable premium payments from buyers like Prudence and Sam. For the seller, it’s a game of probabilities, just like a real insurance company. The danger comes when they get their probabilities spectacularly wrong.

CDSs were not just a sideshow in the 2008 Financial Crisis; they were at its very center. Their structure created two enormous problems that nearly brought down the global financial system.

The ability for speculators to buy “naked” CDSs created a moral hazard and a mountain of hidden risk. The market became a casino where bets on a company's failure vastly outnumbered the actual investments in the company. For example, the total value of CDSs on subprime mortgage bonds was many times greater than the value of the bonds themselves. It was like everyone on a street buying fire insurance on a single house. When that one house caught fire, the “insurance companies” suddenly owed a sum that was orders of magnitude larger than the value of the house.

The most famous protection seller was AIG (American International Group), a massive insurance company. AIG sold tens of billions of dollars worth of CDS protection on mortgage-backed securities, collecting huge premiums and believing a nationwide housing collapse was impossible. When the impossible happened, AIG faced a tidal wave of claims it could not possibly pay. Because AIG was connected to every major bank in the world, its failure would have triggered a domino effect. This is a perfect example of systemic risk—where the failure of one firm threatens the stability of the entire system. The U.S. government was forced to bail out AIG to the tune of $182 billion to prevent a complete meltdown.

For a value investor, CDSs and other complex derivatives are a flashing red light. Warren Buffett famously called them “financial weapons of mass destruction,” and for good reason. A value investing philosophy encourages you to avoid them for several key reasons:

• Complexity: If you can't understand it, don't invest in it. CDSs are notoriously opaque and difficult to value. Your time is better spent analyzing a business's balance sheet than trying to decipher a 50-page derivative contract.
• Counterparty Risk: Your CDS is only as good as the party who sold it to you. As the AIG saga shows, your “insurance” can vanish right when you need it most if your counterparty goes under.
• Focus on Quality, Not Insurance: If you're buying a bond or stock and feel you need to buy a complex derivative to protect you from it, you are asking the wrong question. A true value investor's “insurance” is buying a wonderful business at a fair price—one with low debt, durable competitive advantages, and honest management. Why bet on a horse and then pay extra for insurance in case it breaks its leg? Just bet on a healthier horse.