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Financial weapons of mass destruction

Why Warren Buffett called Credit Default Swaps financial weapons of mass destruction. Created by Sal Khan.

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  • blobby green style avatar for user Bill
    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)
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    • 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)
  • blobby green style avatar for user Coquin03
    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)
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    • 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)
  • blobby green style avatar for user Santosh Vazarkar
    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)
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    • blobby green style avatar for user ktiwari.02
      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)
  • leafers tree style avatar for user Michael Baker
    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)
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  • aqualine seed style avatar for user K B
    Instead 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)
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    • male robot hal style avatar for user Andrew M
      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)
  • leaf green style avatar for user Ibrahim Abdul Rahim
    the 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)
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  • blobby green style avatar for user jsalacus
    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)
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  • blobby green style avatar for user ying xing ng
    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)
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    • ohnoes default style avatar for user Tejas
      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)
  • duskpin seed style avatar for user davinci.rishi
    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)
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  • male robot donald style avatar for user harry park
    How is Credit Default Swap accounted for in the Balance Sheet?
    (1 vote)
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Video 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.