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.
Two outcomes are possible:
There are two main reasons someone would buy a CDS:
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: