If you're seeing this message, it means we're having trouble loading external resources on our website.

If you're behind a web filter, please make sure that the domains *.kastatic.org and *.kasandbox.org are unblocked.

Main content
Current time:0:00Total duration:4:31

Video transcript

let's think about the different use cases for credit default swap so let's say that I have some company over here and it's been it's given a double B credit rating and this rating of course comes from a credit rating agency credit rating agency sometimes called a ratings agency or a rating agency I've seen at every different way so this would be like Moody's or Standard & Poor's or whatever else and they say they look at this company and they look at its business they look at its balance sheet they say okay it's not super safe but it's not super risky either we give it a double B rating and let's say that there's an investor over here who wants to lend money to this company so he might lend them some money and get some interest in return get some interest in return but this investor doesn't like this this level of safety he wants to get he wants to make sure that he's made whole even if this company goes out of business so he can go to a writer of a credit default swap and the most famous of those credit default swap writers is or was AIG and he'll say hey IG I'm going to pay you a little bit every year you can view that as an insurance premium and in exchange you are essentially going to insure you're going to insure me in the case of a default by this company insurance and what we already said it's a little bit shady because a it was not regulated like insurance so AIG did not have to set anything aside and what was powerful here for AIG is that the rating agencies continue to give AIG a very high rating so let's say it had a double-a rating so despite the fact that it kept taking on all of these liabilities the credit rating agency says hey we'll still give you a double-a so they were able to use this double-a rating to keep writing these contracts to keep writing insurance not setting anything aside and essentially just getting almost you could view it free money with eventually having to pay the piper eventually now this is one scenario another scenario is maybe an investment bank creates some type of special-purpose entity or some collateralized debt obligation right over here and what they could they have their different tranches and maybe for their for the senior tranche over here just so that they can sell them to pension funds who can only buy Double A rated Det pension funds the investment bank goes to AIG and says hey can this entity right over here by credit default swaps can get can we enter into credit default swap agreements on you so that in case any of this stuff were to default you will also ensure that and once we do that then a rating agency so this is a security this is the senior tranche of a credit of a collateralized debt obligation now the senior tranche and now that that senior tranche is essentially insured by AIG a credit rating agencies credit rating agency once again will assign this a double-a rating even though this thing might be made up of a bunch of subprime mortgages and all of the rest although it is the senior tranche so it'll get be made whole first but now pension funds can buy this type of thing the last use case is maybe you have a hedge fund out here hedge fund out here who it doesn't want to lend anybody any money but it's convinced that about a whole bunch of these companies maybe this company over here or maybe this company over here that has a that has some other ratings so this is another company this hedge fund is convinced that these companies aren't are going to default on their debt that there's going to be a credit crisis of some kind well then this hedge fund can enter into credit default swap agreements could enter into credit default swap agreements to essentially get insurance but not having anything to insure it's like getting car insurance on someone else's on someone else's driving or someone else's car and you kind of are starting to hope that they have to have a car accident because now if this guy has a credit default swap on company on this company right over here despite the fact that they didn't lend out to them the hedge fund is going to pay a little bit every year and get the insurance and the they're essentially going to hope that this company goes out of business because if it does then they're going to get the insurance payment they're going to get the same payment that this investor would have but they would have never had to lend the money so you could use it as a side bet you could use it as a way of making lower rated securities all of a sudden acceptable to pension funds or you could use it as a straight-up way of insuring debt you're lending to someone else