Main content
Finance and capital markets
Financial weapons of mass destruction
Why Warren Buffett called Credit Default Swaps financial weapons of mass destruction. Created by Sal Khan.
Want to join the conversation?
So what the hedge funds bought really isn't insurance, is it? You have to have an "insurable interest" in order to buy insurance, right? In this case the hedge funds don't have any potential loss if the company goes out of business, so it's probably not accurate to call their hedges "insurance". "Bet's" does sound about right to me.(10 votes)- You are correct. Since there is no "insurable interest" (a legal concept), CDS are not legally "insurance" and are not regulated like insurance products are. People use the term "insurance" to describe the practical effect of buying a CDS, that is, to get financial protection from a potential economic loss, in this case the possibility that a borrower will fail to pay principal and interest on its bonds on time. Think of a CDS as an agreement between LBH (a Lender and a Bond Holder) and CDSW (a Credit Default Swap Writer that LBH pays a fee to for a CDS on certain bonds) as follows.
LBH has loaned money to Borrower in return for Bonds. Bonds are Borrower's written promises to LBH to pay back LBH the amount loaned plus interest on time. If Borrower defaults (that is, fails to pay back LBH on time), the CDS agreement permits LBH to transfer the Bonds (which are now worth less than before because Borrower has defaulted -- failed to pay on time) to CDSW, and then requires CDSW to pay LBH the full amount that Borrower owes LBH. LBH could say "the CDS I bought from CDSW protected me -- just like an insurance policy would have -- from the the loss on the Bonds I would have incurred when Borrower ran into trouble and stopped paying its debts."(20 votes)
- Why are these side bets allowed? The short term gain by the insurance company is surely outweighted by the massive risk that everything can go sour.(6 votes)
- They are allowed in large part because in 2000 the US Congress passed a Federal law (the "Commodity Futures Modernization Act of 2000") that permitted most businesses and wealthier investors to enter into these agreements (swaps) with virtually no restrictions. Congress did this because swaps were clearly legal in some foreign countries like the UK, whereas US laws were less clear. Assume a businness customer of a bank wanted to purchase from the bank either (1) protection from a potential financial loss or (2) lock in a potential financial gain. In many cases before 2001, a bank would have to do a swap "offshore" in the UK with its UK branch, then have the UK branch do a similar swap with a US branch, then have the US branch offer a similar swap to the bank's US customer to provide that protection or to lock in a gain. US laws made doing these things much more difficult and expensive than in some foreign countries and banks feared that the swap business would be dominated by non-US banks. Congress simplified the law which helped US banks keep swap business (and it's profits) in the US. What Congress, regulators, banks and businesses failed to do was to monitor the growth and complexity of swap markets as they developed in the US and abroad, and to adopt prudent measures to protect businesses, investors and the economy in the event of an economic downturn.(23 votes)
- In the example Sal mentioned that AIG may be insuring $1 Billion in debt of the company but may be on the hook for $4 or $5 billion given the various CDS it wrote. But instead of paying out $4 or $5 billion to its CDS counter parties would it not make sense for AIG to just shell out that $1 billion to the company which is going to default essentially prevent the credit default; so it does not have to pay out for all the CDS obligations ? I believe that is a much better deal for AIG(3 votes)
- That would not happen in reality, because as soon as the borrower company defaults on its debt, AIG will have to pay the insurances. If you're talking about the situation when AIG 'somehow' knows beforehand that the company is going to default on the debt and pays it $1 billion to save itself, then every single company in the world would take a gigantic loan, float information that it is going to default on it, take the payment from AIG and then announce it is going to default, ending up with a lot of money and disappear.(3 votes)
When the ratings agencies are suggested to be sloppy, isn't it also a possibility that they knew that the writer had a less than perfect credit rating? It may have reached the point where prematurely downgrading a writer's credit rating could have caused the chain reaction as well.(2 votes)
Anything is possible, but when issuers pay ratings agencies to rate their securities, the conflicts of interest tend to be skewed in one direction.(4 votes)
3:07Instead of betting for whether a Corp will fail or not, can these third parties bet for whether a corp will succeed in paying its debt or not & if Corp succeed in paying debt they get money on that?(1 vote)
Every bet involves two sides. If you bet that a company will fail, someone has to take that bet. The one who took the bet is betting the company does not fail. Either side can initiate the bet as long as they can find a counterpart.(3 votes)
- 0:41the video blames the ratings agency and the writers for the mess. what obligations do investors and pensions funds have in determining whether to trust the credit default swaps, and to trust the AA rating. Are they obligated to take a second look? Did they know credit default swaps are unregulated? Do they have any obligations to only enter into regulated instruments?(1 vote)
- Pension funds can invest in just about anything their boards of directors authorized them to invest in.(2 votes)
- I understand most of what has been said. However, the financial crisis seems to have been caused in large part by CDO, in particular CDO associated with mortgages. How are CDS specifically associated with mortgages?
Thanks for these videos!(1 vote)- CDS is insurance on the performance of a CDO (or other debt instrument).
If the CDO is in trouble, the seller of the CDS is in trouble, too.(2 votes)
- When these corporations default, do the investors still have legal rights to chase and recover the debt? So in a perfect scenario, investors would get back their full capital (from writers) and potentially a little more (from their debt recovery efforts)?(1 vote)
What would happen is that all of the assets of the corporation would be sold off, probably at a massively discounted price, and the proceeds would be used to pay the investors.
The buyers of the assets would still be able to chase the homeowners and recover their debts, ... unless the homeowners themselves have defaulted, which they probably would have, because it was almost certainly the homeowners' defaults that caused the corporation to default in the first place.(2 votes)
When a company that has sold debt defaults, why is only the principal considered for insurance under the CDS setup? Wouldn't it make sense for CDS buyers to setup the CDS so that in case of a default, the CDS seller owes them not only the principal on the bond, but also the coupon payments accrued?(1 vote)
How is Credit Default Swap accounted for in the Balance Sheet?(1 vote)
3:07Video transcript
Let's think a
little bit about why credit default
swaps, or famously referred to by Warren
Buffett as financial weapons of mass destruction. At the center of
it-- and there's not just one credit
default swap writer, but I'll put one in the
middle because each of them are writing many, many
credit default swaps. AIG is the most famous. But you have some writer here. They're given some
good credit rating. Maybe in the past
that credit rating was actually earned by
a credit rating agency. And then frankly, the
credit rating agency got a little sloppy and really
wasn't willing to downgrade them given all of
the credit default swaps, all of the obligations
they are taking on. And as you could tell, I kind of
view these guys and these guys as the main culprits,
and maybe a little bit of the regulatory agencies
saying, hey, look, these guys are
writing insurance. Maybe we should
actually regulate them. But with that said, you
have companies over here. I'll do the companies
in this pink color. And they want to borrow
money from other parties, let's say, investors. I'll do the investors
in this orange color. So the investors are
lending them money. The companies give
them interest. So investors lending money,
giving interest, lending money, giving interest, lending
money, giving interest. And then these investors--
it seems pretty reasonable-- say, hey, look, there's a
guy over here with a double A rating. The people that we're lending
to don't have a double A rating. Maybe this guy has a B, maybe
this guy has a double B, maybe this guy only has a
single A. And so he says, look, I want to be
completely safe here so I'm going to pay a
little bit of a premium to AIG or to the writer,
whoever the writer is, and in exchange I will get
insurance on this debt. And it seems pretty
reasonable except for the fact that this player right over here
did not put out any money aside or did not put the
appropriate amount of money aside to properly account for
all of these liabilities, all of this risk that its taking on. And also, all of these
risks are correlated. You can imagine a situation
where the economy goes bad. Now, all of a sudden
this company defaults on its debt and this company
defaults on its debt. In fact, when the
economy's good, it's likely that very
few of these companies are going to default and
when the economy goes bad, it's likely that many
of them will default. But the real problem is is as
soon as these defaults start happening, then the
credit default swap writer is going to have to actually
start paying for the defaults. They'll get the bad debt
and in exchange they'll make the other side
of the credit default swap, the holder of it, they
will pay to make them whole. And so this could take
them out of business. And all of a sudden,
the people over here who thought that they had
insurance no longer do. And they might
actually say, wait, I can only hold double A
debt and they might actually have to dump this
debt on to the market. Even worse, you have all
of the people over here who didn't lend any
money to anybody, but they really just
wanted to make side bets. Either the side bets might
have been pure directional bets on the state of
the economy saying, hey, I think a
bunch of companies or I think this
company in particular is going to default on
its debt, and they too could get credit default swaps
really as just side bets. So just for maybe this right
here is $1 billion in debt, maybe all of these parties
took side bets on this guy. So even though there's only
$1 billion of debt here, there might be $4
or $5 or $10 billion worth of insurance on
that $1 billion bet. So if all of a sudden
this one company can't pay its $1 billion,
now AIG is on the line not for $1 billion, but
for $4 or $5 or $6 billion, however much it insured it for. So it allows people
to insure for things that they don't have the
offsetting liability for. And so you can imagine,
some of these people-- if this guy fails will just take
a loss and that's bad and all of the rest because they
were expecting that they wouldn't-- but some of
these players might have had offsetting hedges. The only reason why they
might have felt comfortable taking on some
other liability is they said, look, if the
economy goes really bad, I have this insurance over here. And they did that transaction
with another third party. Now all of a sudden,
if the economy goes bad and these guys say, hey,
look, I'm in a lot of trouble. Good thing I have this
credit default swap, but then it turns out that they
don't because the counterparty here fails, the credit
default swap writer, now all of a sudden this
guy becomes insolvent. But this guy was dependent
on this guy paying and he thought he was good
because he even looked at this guy's books and said
this guy had offsetting hedges, and now this guy might fail. And so you could have
this entire cascade through the entire
financial system.