Simple Introduction to Credit Default Swaps & Collateralized Debt Obligations
Credit default swaps may sound fiendishly complex, but they’re actually relatively simple instruments. Imagine a family—call it the Bonds family—moves into a beautiful new home worth $1 million recently built in your neighborhood. The local bank has given the Bondses a mortgage. Trouble is, the bank has too many loans on its books and would like to get some of them off its balance sheet. The bank approaches you and your neighbors and asks whether you would be interested in providing insurance against the chance that the Bonds family may one day default.
Of course, the bank will pay you a fee, but nothing extravagant. Mr. and Mrs. Bonds are hardworking. The economy is in solid shape. You think it’s a good bet. The bank starts paying you $10,000 a year. If Mr. and Mrs. Bonds default, you owe $1 million. But as long as Mr. and Mrs. Bonds keep paying their mortgage, everything is fine. It’s almost like free money. In essence, you’ve bought a credit default swap on Mr. and Mrs. Bonds’s house. One day you notice that Mr. Bonds didn’t drive to work in the morning. Later you find out that he’s lost his job. Suddenly you’re worried that you may be on the hook for $1 million. But wait: another neighbor, who thinks he knows the family better than you, is confident that Mr. Bonds will get his job back soon. He’s willing to take over the responsibility for that debt—for a price, of course. He wants $20,000 a year to insure the Bondses’ mortgage. That’s bad news for you, since you have to pay an extra $10,000 a year—but you think it’s worth it because you really don’t want to pay for that $1 million mortgage.
Welcome to the world of credit default swaps trading.
Many CDS traders, such as [Boaz] Weinstein, weren’t really in the game to protect themselves against a loss on a bond or mortgage. Often these investors never actually held the debt in the first place. Instead, they were gambling on the perception of whether a company would default or not.
If all of this weren’t strange enough, things became truly surreal when the world of credit default swaps met the world of securitization. [Aaron] Brown had watched, with some horror, as banks started to bundle securitized loans into a product they called a collateralized debt obligation, or CDO. CDOs were similar to the CMOs (collateralized mortgage obligations) Brown had encountered in the 1980s. But they were more diverse and could be used to package any kind of debt, from mortgages to student loans to credit card debt. Some CDOs were made up of other pieces of CDOs, a Frankenstein-like beast known as CDO-squared. (Eventually there were even CDOs of CDOs of CDOs.)
Just when things seemingly couldn’t get stranger, CDOs underwent a completely new twist when a team of J. P. Morgan quants created one of the most bizarre and ultimately destructive financial products ever designed: the “synthetic” CDO.
In the mid-1990s, a New York group of J. P. Morgan financial engineers began thinking about how to solve a problem that plagued the bank: a huge inventory of loans on the bank’s balance sheet that was earning paltry returns. Because the bank was limited in how many loans it could make due to capital reserve requirements, those loans were holding it back. What if there was a way to make the risk of the loans disappear?
Enter the credit default swap. The bank came up with the novel idea of creating a synthetic CDO using swaps. The swaps were tied to the loans that had been sitting on J. P. Morgan’s balance sheet, repackaged into a CDO. Investors, instead of buying an actual bundle of bonds—getting the yield on the bonds, but also assuming the risk of default—were instead agreeing to insure a bundle of bonds, getting paid by a premium to do so. Imagine, in other words, thousands of swaps tied to bundles of mortgages (or other kinds of loans such as corporate and credit card debt) such as those owned by Mr. and Mrs. Bonds.
By selling slices of synthetic CDOs to investors, J. P. Morgan offloaded the risk of the debt it held on its balance sheet. Since the bank was essentially insuring the loans, it didn’t need to worry anymore about the risk the loan holder would default. With that—presto change-o—the bank could use more capital to make more loans … and book more fees.
Patterson, S. (2010). The Quants: How a New Breed of Math Whizzes Conquered Wall Street and Nearly Destroyed It. New York: Crown Business, pg. 167-8