How do credit default swaps work?


Announcer: Welcome to Stuff You Should Know from HowStuffWorks.com.

Josh Clark: Hey, and welcome to the podcast. I'm Josh Clark, and guess who is with me.

Chuck Bryant: Ronald McDonald.

Josh Clark: Yes. Yeah. I met Ronald McDonald at my cousin's 15th birthday party.

Chuck Bryant: Really?

Josh Clark: Yeah, he's pretty cool.

Chuck Bryant: Isn't that weird? That's the first thing that came into my head. I guess it means I'm hungry.

Josh Clark: I guess so. Are you hungry? Did you eat today?

Chuck Bryant: No.

Josh Clark: This is going to be a fun one, Chuck. We're talking about credit default swaps.

Chuck Bryant: Oh.

Josh Clark: I know, we're going to try to make it sexy.

Chuck Bryant: Yes. Should I go ahead and give the caveat here?

Josh Clark: If you want. Go ahead.

Chuck Bryant: I just want folks to know we usually - Josh and I do a lot of prep work and both have a pretty good understanding, but I'm not ashamed to admit that I didn't quite understand this one.

Josh Clark: It's pretty thick, Chuck.

Chuck Bryant: Might be a little different today. Josh is going to be teaching me along with you.

Josh Clark: Are you prepared?

Chuck Bryant: As prepared as I can be.

Josh Clark: I appreciate you dressing like a little school girl today to really kind of complete everything and round it out.

Chuck Bryant: Yeah, yeah.

Josh Clark: Okay, so let me give you an analogy. So Chuck, imagine if I went to your health insurance provider and said, "Hey, I want to buy Chuck's policy," and they said, "Okay," and they sold it to me.

Chuck Bryant: And you would be in charge of that policy.

Josh Clark: I would own the policy, so I would be accepting monthly payments from you. Everything would be fine. I'd be probably running around trying to keep you out of accidents, that kind of thing. But if you did get into an accident, I would be on the hook to pay your medical expenses. Right?

Chuck Bryant: You bet you would be.

Josh Clark: You and I are both fully aware that I don't have the money to pay your medical expenses.

Chuck Bryant: No.

Josh Clark: So basically what would happen is I'd pay as much as I could until I bankrupted myself, and then you'd be on the hook to pay your medical expenses.

Chuck Bryant: Okay, I get that.

Josh Clark: So you'd be in trouble. It'd bankrupt you, and we'd both be up the creek.

Chuck Bryant: I understand so far.

Josh Clark: Are you with me so far?

Chuck Bryant: Yeah, it makes sense.

Josh Clark: Now imagine if you owned two other peoples' life - or health insurance policies just like I owned yours. Okay. Now let's say that accident you got into was a three car pileup just in a mind boggling coincidence with the other two people whose health insurance policies you owned.

Chuck Bryant: Okay, I'm with you.

Josh Clark: So now, all of a sudden, you guys are all in an accident, all need healthcare and nobody has the money to pay out. I can't pay yours, and you have your own problems, so you can't pay the other two people. So imagine if this just keeps going on and on and on and on in this infinite car pileup, and everybody owns everybody else's insurance policy, but nobody can pay. Okay?

Chuck Bryant: Okay, that's awful.

Josh Clark: It is awful. It's kind of nightmarish. Right?

Chuck Bryant: It is.

Josh Clark: So the good thing is this can't happen because health insurance is a heavily regulated industry, so you've got - you have federal inspectors who can go to a health insurer and say, "Let me see your books. I want to make sure you can cover every policy that you have."

Chuck Bryant: Do they do that?

Josh Clark: Yeah. And what's more, they can't sell your insurance policy to anybody.

Chuck Bryant: Right, thankfully.

Josh Clark: Right. With credit default swaps, all the good things that keep health insurance from going pear shaped are not present, although they are pretty much insurance policies on debt. Okay?

Chuck Bryant: Okay, this is where I start to get a little fuzzy.

Josh Clark: I understand. It does get a little fuzzy at this point.

Chuck Bryant: It's a bit of an abstract - it's a bit abstract for me.

Josh Clark: It is. It's insane. You have to be a genuinely savvy person and possibly a bit evil to be able to really accurately trade or make money in credit default swaps.

Chuck Bryant: Okay, but you don't have to be evil to describe them to people in podcast land.

Josh Clark: No, you just have to read the article several times, and write it, too. It doesn't hurt to write it.

Chuck Bryant: I read it several times, and it was still a little bit -

Josh Clark: Maybe you have to write it. Write it out. So let me give you a little bit of background. Credit default swaps are these financial instruments that came out of the late '90s. Right?

Chuck Bryant: It's a derivative.

Josh Clark: It is a derivative, and a derivative is -

Chuck Bryant: A derivative - I do know this. It's a financial instrument that has a value based on the value of another financial instrument.

Josh Clark: Right. So let's say you're trading in oil futures. Right? That actually - the value of that future is based on the value of oil. It has an actual value. With this, this would be based on future - an oil future, so it doesn't have its own value. Its value is based on the value of something else. So let's say you bought a bunch of oil futures and you were worried that the price of oil was going to go down. And so you'd be getting the oil, cheaper oil for than what you paid for it. You would lose money. You could - I'm not sure if you could or not, but let's say theoretically, you could buy a credit default swap to cover that eventuality.

Chuck Bryant: So it's like insurance still.

Josh Clark: That's exactly what it is. So in the '90s, they started issuing these things, municipal bonds, which were about as safe as it gets. Almost every city, except for probably Detroit, has a Triple A credit rating.

Chuck Bryant: So a municipal bond is a loan made to a city to finance a project. That's why it's a little more stable than your average situation.

Josh Clark: Right, and a city can tax its citizens to pay off its debts, which is one of the reasons why they're so stable, reliable, and credit worthy. Right?

Chuck Bryant: Gotcha.

Josh Clark: So the thing is that all these banks that are issuing these policies are saying, "You know what? We're making just tons of extra income because they're selling these credit default swaps to people who are loaning money to cities. The cities are definitely paying it back, so there's no default on the loan, and so the banks are just raking in extra money." So these things started to take off like a rocket.

Chuck Bryant: Who is they? That's what I'm confused about. That's the bank? They actually issue these?

Josh Clark: Okay, so let's say that I have a bunch of money, and Atlanta needs to repay 400.

Chuck Bryant: Okay.

Josh Clark: So I buy a bunch of city bonds, a bunch of municipal bonds, which are basically - it's a city issuing debt. I give them a bunch of money, and they give me a bond in return to hang onto - and it will earn slow, steady, small interest. I would buy a credit default swap from a bank to say if this city doesn't pay me back, then I can cash in this credit default swap, this insurance policy against the loan I gave the city. And then I'll actually make more money because like a life insurance policy, it's worth more than say the actual loan.

Chuck Bryant: Okay, see, coming into focus.

Josh Clark: Is it?

Chuck Bryant: Yeah. We should talk together before do these?

Josh Clark: It would ruin everything.

Chuck Bryant: Yeah, I guess you're right.

Josh Clark: So it made a huge source of extra income for the banks that were issuing these insurance policies because no municipality was defaulting on their loans. So they started to look for other places where they could sell these things or people they could sell them to. And essentially, you can cover any debt whatsoever with a credit default swap.

Chuck Bryant: That's amazing to me, and I think one of the reasons why it was able to take off like this is because they're unregulated. It seems like greed, as always, kind of takes hold, and they're like, "Hey, if we do it for this, we can do it for this." Is that how it worked?

Josh Clark: They are wholly and completely, to this day, unregulated.

Chuck Bryant: It's amazing.

Josh Clark: So which is why that scenario that I gave you at the beginning about your health insurance policy, that's dead on with credit default swap. So let's think about this. Say a bank issues a credit default obligation to somebody who has created debt. Right? That guy who loaned money to the city for that road project. So he buys a credit default swap. Now there's two players in this one, really, as far as the insurance policy goes. You've got the bank, who has the issuers side of it, and then you've got me, the guy who made the loan to the city, who has the buyer's side of it.

Chuck Bryant: And do you pay a premium like regular insurance?

Josh Clark: Yeah, like a monthly premium. Right. And then, both of the sides of this policy can be sold to anybody at any time who wants to buy them, and neither side needs to notify the other person.

Chuck Bryant: Really?

Josh Clark: What's more, because its unregulated, if the bank sells it to you - so now you own the issuer portion of my credit default swap, so I'm now making payments to you. You don't have to prove to them at all whether you have the money to cover it if the city defaults on the loan.

Chuck Bryant: This sounds - two things this strikes me. It sounds like la la land, and it sounds like a really bad idea.

Josh Clark: It is. Because Chuck, here is the problem. If we haven't come up with enough problems yet, since it's also unregulated, the way that a credit default swap can be called in if I'm the buyer is through a credit event, and there's certain credit events. One of the big ones is bankruptcy. One of them is if the city just says, "We're not repaying your loan." That would be a credit event. And then that triggers payment. The problem is since they're unregulated; anybody can dispute whether or not a credit even actually took place, whether the event that the buyer is saying, "Give me my money," over actually was a credit event. So there's mediation. There's lawsuits.

Chuck Bryant: Well, who do they dispute it to, though, since there's no body?

Josh Clark: They take the other person to court.

Chuck Bryant: Oh, they just start suing each other?

Josh Clark: Yes.

Chuck Bryant: More litigation. That's exactly what we need.

Josh Clark: Right. The thing is its still, like I said, to this day unregulated. There is actually an independent body of banks and investment houses and other investors and securities analysts, I believe, who have come together to form an arbitrating panel for credit default swaps.

Chuck Bryant: That's a good thing. Right?

Josh Clark: It is a good thing. But again, it exists outside of the government. So everybody who is involved in the credit default market had to agree, "Yes, we'll listen to these people. Their decision is binding."

Chuck Bryant: But existing outside the government isn't necessarily a bad thing.

Josh Clark: No, it isn't. But I think to me, it's just kind of one more point, like where is the SEC? And I actually read that the SEC and the treasury department were encouraging this panel to form. Like, "Please, go handle this for us because we don't have any teeth whatsoever." So yeah, that's the problem with it being unregulated. Right?

Chuck Bryant: Well, it sounds like it's ripe for a nightmare scenario, too. Like you first were talking about!

Josh Clark: Let me set the stage for you. Okay?

Chuck Bryant: Okay.

Josh Clark: In July 2007, you remember the good heady days of the bubble before it burst?

Chuck Bryant: Oh, yeah.

Josh Clark: Okay. The sub prime mortgage market was valued at - let's see. I think $7 trillion in the US.

Chuck Bryant: In the US alone.

Josh Clark: In the US, but the US was, I think, the biggest player in the subprime mortgage market. Right?

Chuck Bryant: Oh, sure.

Josh Clark: And this is when the subprime mortgage market was still valuable. So 7 trillion! Do you know in July 2007 what the credit default swaps market was valued at?

Chuck Bryant: I do, but I'm going to let you say it.

Josh Clark: Are you ready? $62 trillion!

Chuck Bryant: That's unbelievable.

Josh Clark: Do you know what the global GDP was for 2008?

Chuck Bryant: I do, but I'm going to let you say it.

Josh Clark: You ready?

Chuck Bryant: Yeah.

Josh Clark: $69 trillion.

Chuck Bryant: Wow. So it's just short of the global GDP.

Josh Clark: So basically, if every country in the entire world could suddenly sell off -

Chuck Bryant: Everything they produced.

Josh Clark: Every good and service it produced in a year to say, some aliens, we'd still have $5 trillion left over for the year.

Chuck Bryant: It sounds like this is the biggest market of anything in the world almost.

Josh Clark: Yes, I think so. I can't think of anything that's valued at more than that. And it just - think about it. This was the late '90s. So in a decade, this unregulated market went from zero to 62 trillion.

Chuck Bryant: Well, what's amazing is you reference the mortgage crisis, and that's a scenario that you can track it down to a house eventually, like a physical property, but this is sort of like exist in the ether. So there's no end of the line it seems like.

Josh Clark: No, there isn't, which is why you can say, "No, a credit event didn't occur," or, "No, I'm not going to pay up." Or, "I don't have the money to pay up. I'm sorry. I was enjoying the monthly payments you were paying me, and I really thought you were going to be okay, but now that you've gone under, I can't pay you the money that I owe you."

Chuck Bryant: So where does this lead us?

Josh Clark: Well, hold on. Let me say one more thing. The whole reason this market blew up is because there's actually a way to bet on the health of a company. Right? So if you have a bunch of investors who have buyer shares of credit default swaps, then they're saying they think that that company is going to go under because they're paying monthly premiums, but it's on the premise that that company is going to go under, and there will be a much bigger payout in the end.

Chuck Bryant: Right. You can do that with stocks, too.

Josh Clark: Yes. Even more, you can actually short sell a company, driving its value down if you own enough shares or if you can borrow enough shares and sell them on a margin. If you have credit default swaps, it'll actually be a bigger payout if you can drive that company into bankruptcy because you've just created a credit event.

Chuck Bryant: That seems unbelievable.

Josh Clark: Okay, so this was where the world was teetering right now in 2007, 2008. Lehman Brothers actually went down not because of subprime mortgage securities, but because of all the credit default swaps. This huge domino defect was triggered. A bunch of people had credit default swaps on the subprime mortgage securities that they owned. Right?

Chuck Bryant: Oops.

Josh Clark: Oops indeed. So when the subprime mortgage securities went south, everybody turned to their credit default swaps and went, "Whoa, I'm glad I have these." Now wait a minute, who owns my policy? Because there's no paper trail whatsoever. You have to track down who owns it and then hope that they have the money to pay you. All these banks were finding out the people that own their insurers' policy didn't have the money to pay them. The problem is when you're writing your balance sheet, if you have a major loss but you have a credit default swap that covers it and it pays out, you're fine. You're staying in the red and you probably actually made a little bit of money. If you have a major loss and there is no credit default swap to cover or it can't be covered, then that's when your balance sheet goes into - I'm sorry, into the red, which is the bad one.

Chuck Bryant: Right, I get that.

Josh Clark: So that's what happened with Lehman Brothers. That's why AIG got all that bailout money because they had a bunch of credit default swaps. And now, there is this panel that I talked about, the independent panel, that's actually gotten the value of the market down to about $25 trillion.

Chuck Bryant: I wonder how independent they are.

Josh Clark: Yeah, I think it's all probably revolving door stuff. Like if they haven't held public office in the last couple of years, they will soon.

Chuck Bryant: They all work for Goldman Sachs.

Josh Clark: I think Goldman Sachs is a major player in that panel.

Chuck Bryant: Of course. Well, this sounds like I get it now.

Josh Clark: Do you really?

Chuck Bryant: Yeah, yeah. So thanks for that.

Josh Clark: Thank you.

Chuck Bryant: Where does this lead? I mean is this - something has got to happen at some point it seems like, or else it's setting us up for even more failure economically. Or no?

Josh Clark: No, no, most definitely. I think it's just it seems like the credit default swap's market is being tamed. Like I've said, we've gone from $62 trillion to $25 trillion in just like two years.

Chuck Bryant: Okay, well, that's good.

Josh Clark: But I think it's symptomatic of the lack of regulation and oversight that we've had. We have the SEC, but they don't have any teeth, and the teeth that they do have are dull and can basically just gum butter. And then the fact that there is whole over the counter markets that are allowed to get this big without any regulation whatsoever, it seems that there seems to be a pattern, Chuck. Like the Great Depression was the result of complete and total lack of oversight and regulation mixed with unbridled greed. Right?

Chuck Bryant: Right.

Josh Clark: So then we come up with things like the SEC, the FDA, all these things that - all these regulatory bodies that came out of the Great Depression and the crash to prevent it from happening again. Then we got lazy. So then this happened again. There's going to be more regulation. The problem is people always say - pro-business people always say, "Regulation strangles business." I disagree. I think the whole point to capitalism is to make as much money as you can as fast as you can. Right? Which means that no matter how many roadblocks the government throws up, all its doing is presenting challenges for very clever, greedy people?

Chuck Bryant: And it happens.

Josh Clark: They'll always find a loophole.

Chuck Bryant: Oh, yeah. Always! That's very interesting.

Josh Clark: So I think that's where it's leading us to more regulation, but I don't think there's ever going to be a saving grace where nothing like this ever happens again.

Chuck Bryant: Right. When you're talking now $25 trillion, that's still such a massive amount that it's kind of frightening to think about.

Josh Clark: It is, but it's doable.

Chuck Bryant: It is?

Josh Clark: I think if the US, Japan, and the UK got together and sold everything off in a fire sale, we could cover it.

Chuck Bryant: Good to know. Well, I get it.

Josh Clark: Thanks, good. I'm feeling pretty good about myself.

Chuck Bryant: Well, you should.

Josh Clark: Credit default swaps ahoy.

Chuck Bryant: Yeah, this was sort of like some math just goes so far above my head. I can read it and read it and read it, and it still just doesn't sink in.

Josh Clark: I'm like that with algebra. I get geometry, but not algebra.

Chuck Bryant: We should do a podcast on it and fumble our way through that.

Josh Clark: Yeah, so there you have it, Chuck.

Chuck Bryant: Awesome.

Josh Clark: Are we still plugging things anymore?

Chuck Bryant: Sure, Josh. We'll just give a quickie plug to the blog. Stuff You Should Know blog that we write once a day each, and it's on the right side of the homepage, and it's been enjoyable, and that's all we need to say.

Josh Clark: Yes, that is it. So then what does that mean, Chuck? It's listener mail time?

Chuck Bryant: It is indeed. Josh, this one I'm really looking forward to reading.

Josh Clark: Which one is it?

Chuck Bryant: This is the I me incident.

Josh Clark: We've been getting a lot of these.

Chuck Bryant: For those of you - obviously, you don't know because you don't go to listener mail. We have a lot of people that take us to task on the use of I and me, Josh an I, Josh and me, me and Josh, I and Josh.

Josh Clark: I seem to get it a lot more than you, though.

Chuck Bryant: Oh, we both do.

Josh Clark: Do we? Okay.

Chuck Bryant: So people take us to task and tell us that we're not being responsible with our grammar, and I got this e-mail from Keith in Alton, Illinois. Keith says, "I just want to let you know as a student of linguistics, I'd like to tell you that in a compound object, e.g., send listener mail to Chuck and I/me, it is totally fine to use whichever pronoun you think sounds better. I've read a lengthy explanation that justifies the use of I in a compound object, but I won't bore you with it. My main point is this. Talk in whatever way sounds right to you while keeping in mind that certain non-standard usage of words might put off some snooty pedants.

Josh Clark: Awesome, Keith.

Chuck Bryant: And he did actually send a link. I'm not going to bore you, either, but there was a book by Steven Pinker called The Language Instinct, and I mean he sent me a whole page where the guy basically breaks it down. And in the end, I'll just read the one sentence -

Josh Clark: Steven Pinker. Really?

Chuck Bryant: Yeah. Do you know him?

Josh Clark: I just heard of him last night for the first time.

Chuck Bryant: Really?

Josh Clark: Yeah, that's odd.

Chuck Bryant: So the last sentence of his thing says, "By the logic of grammar, the pronoun is free to have any case it wants."

Josh Clark: I agree. I think the point of communication is to get your idea across to somebody, and I think interchanging I or me still gets the point across. I think if you can get your point across with grunts and hand gestures, that's proper communication.

Chuck Bryant: Right and when it comes down to it, the name of this show is not grammar you should know, and we are always the first ones to say we're not perfect. So lay off.

Josh Clark: A matter of fact, Keith, go ahead and send us your address because we're going to send you a t-shirt, my man. That was cool. Thanks for coming to the rescue.

Chuck Bryant: Yeah, Keith. Shirt size and address, and we'll thank you for having our backs on this.

Josh Clark: Right on. So if you want to have our backs, if you want to take us to task, if you're a grammar Nazi or a - whatever. How about we re-record that part? Ready? So if you want to have our backs, or if you want to take us to task like the grammar Nazis that rode in, just go ahead and send us an e-mail to StuffPodcast@HowStuffWorks.com.

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