Credit Default Swaps (CDS) Sold as Safe are Potentially Toxic Waste

Credit default swaps (CDS) are designer-made financial derivative vehicles, in the form of contracts, which have been used for decades by the world’s largest insurance and other financial institutions as a form of investment insurance . More recently, such “swaps” contracts have greatly expanded into mega-trillions of dollars of “counter party” contracts between all types of investers covering all types of “bets” on future events. While some CDS’s simply cover the small risk of default of the highest grade of debt instruments, others are tied to such investments as super-risky subprime mortgage-backed debt obligations. As well, even the potentially safest of CDS’s have been converted into dangerous investments through leverage and/or “tranching”.

Credit default swaps are often so complicated and difficult to understand that these can be presented as a safe and viable investment to even sophisticated institutional investors including pension funds, credit unions mid-sized and smaller financial institutions, as well as school districts and other governmental subdivisions. CDS were often marketed to such investors under the claim that these could provide a higher return than “comparable” investments. However, the risk of the CDO’s was often far greater than those investments to which these were being compared.

The easiest way to understand ‘credit default swaps’ is to think about them in terms of their name. What is ‘swapped” is the risk of default inherent in debt obligations. In other words, a CDS is a contract by which a holder or buyer of a debt obligation (i.e., corporate or other bond or debt) hedges protects himself against the risk of a potential loss that may occur if the issuer of the debt obligation (the issuer of the bond or borrowert) defaults on the bond or debt.

The holder’s counterparty is the so-called “seller” of the CDS (“protection-seller”). The holder (“protection-buyer”) promises to pay the protection-seller a fixed-rate monthly payment for the term of the contract. This payment somewhat resembles the premium you pay for your car or home insurer. If and when the company/borrower issued the bond defaults (or otherwise triggers what is called a “credit event”), the protection-seller agrees to compensate the protection-buyer for his loss. The loss is usually calculated as either the par value of the underlying bond or the difference between the par value and any remaining market value of the bond at the time of the default.

These instruments can be bought and sold from both ends – the protection buyer or seller. The only condition is that both counterparties to the contract agree to the sale. This means that as long as a purchaser of a CDS who buys it in the posture of a protection-seller is willing to pay its price, a completely insolvent person or institution could end up as the ultimate “insurer” against whom a protection buyer must assert his claim for payment if the underlying bond is defaulted upon or if another so-called “credit event” occurs. That means a lot of people or companies who thought they bought “insurance” against future credit losses have actually bought themselves an empty bag.

There may, but need not necessarily be, an underlying bond or other debt obligation for which insurance is purchased. CDS’ can be purely speculative bets on market conditions, for example they can constitute bets that 5-year US treasury or 30 year corporate bonds reach a certain price level. Once that price level is reached, the seller agrees to pay the buyer a predetermined amount of money.

Following are the actual terms employed in most CDS contracts: We have so far avoided them since they sound more confusing than they need to be. We will use the terms we employ on this page and list the commonly used terms next to them in parentheses.

• Protection-buyer (“buyer” or “fixed-rate payer”)
• Protection-seller (“seller” or “floating-rate payer”)
• Bond (“debt obligation”)
• Bond issuer (“reference entity”)
• Default (“credit event”)

Short of a complete default by the bond issuer, common “credit events” include any “restructuring” or rescheduling/renegotiating of the issuing entity’s payment obligations to its own creditors.

There are entities that specialize in dealing in CDS’, acting like brokers or middlemen between willing buyers and sellers of these bets or hedging instruments, for a fee.] These CDS’ are also often sold and resold many times in the secondary market, which is completely unregulated. This means that a secondary-market purchaser of one of these contracts can be several transactions removed from the original parties to the contract, and so often has no means of assessing the solvency of the original protection-seller of the contract. Either that, or the solvency of the protection-seller may have changed dramatically since the contract/CDS was written.

In the current climate where even venerated US financial institutions go bankrupt or have to sell themselves to other entities in order to stay solvent, this becomes critical. If you are the protection-buyer of a CDS whose current protection-seller is (was) Lehman Brothers, for example, you can see where this can lead. CDS buyers are unsecured creditors, and are therefore last in line with all other creditors if the protection-seller goes bust.

It is at this point that legal battles can arise. Aside from simple breach of contract situations where the protection-seller refuses or is unable to make good on his original promise to pay in case of default, many dealers in CDS’s have misrepresented the safety of these instruments to even experienced purchasers. Why? Because the complexity, lack of transparency and liquidity in the CDS market alowed sales mark-ups on such securities far greater than other investments.

Our securities law firm has with attorneys and staff who have more than 100 years of combined experience in the securities industry and securities law and is currently representing a number of Institutional Investors those who were sold Credit Default Swap (CDO) securities.