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Credit default swaps 2 | Finance & Capital Markets | Khan Academy - YouTube
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So let's see if we can get a
big picture of everything
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that's happening in this credit
default swap market.
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I'll speak in generalities.
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Let's say we have Corporation
A, Corporation
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B, Corporation C.
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And let's say we have a bunch of
people who write the credit
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default swaps, and I'll
call them insurers.
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Because that's essentially what
a credit default swap is,
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it's insurance on debt.
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If someone doesn't pay the
debt, then the insurance
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company will pay it for you.
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In exchange, you're essentially
giving some of the
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interest on the debt.
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So let's say we have Insurer
1, let's say we
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have Insurer 2.
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And some of these were insurance
companies, some of
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these were banks.
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Some of these may have even
been hedge funds.
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So these are the people who
write the credit default
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swaps, and then there are the
people who would actually buy
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the credit default swaps.
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In the previous example, I had
Pension Fund 1, that was my
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pension fund.
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Then you could have another
pension fund, Pension Fund 2.
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Let's re-draw some of the
connections between the
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organizations.
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Let's say Pension Fund 1 were
to lend $1 billion to A.
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A will pay Pension Fund 1 10%.
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But Pension Fund 1 wants to
make sure that they'll
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definitely get the money,
because they can't lend money
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to people with anything less
than stellar credit ratings.
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So they get some insurance
from Insurer 1.
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So what they do is out of this
10%, they pay them some of the
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basis points.
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So let's say they pay them
100 basis points.
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And in exchange, they get-- I'll
call it Insurance On A.
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This is this new notation
that I'm creating.
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They get Insurance On A.
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Fair enough.
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And the reason why this I1, this
first insurer was able to
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do that is because Moody's
has given them a
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very high credit rating.
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And so when they insure
something, you're essentially
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the total package, right?
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The loan to this guy, plus the
insurance, kind of is like
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you're lending the money to
this guy, but you're just
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getting more insurance-- I
mean you're getting more
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interest, right?
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So this bond becomes
a Double A bond.
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Because the odds that you are
not going to get your money
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are not the odds that this guy
defaults, but it's now the
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odds that this guy defaults.
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And Moody's or the standard is
poor, as I've already said.
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Hey, these guys are good for
their money, they're Double A
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or whatever.
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So now your risk is really a
Double A risk and not a Double
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B risk, or whatever.
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But anyway, this happens.
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This is Corporation B, and maybe
Pension Fund 2 wants to
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lend to Corporation B.
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Maybe they lend them
$2 billion.
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They get, I don't know, they get
12%, maybe Corporation B
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is a little bit more
dangerous.
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But once again, they go
to this first insurer.
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And maybe they get some of it--
well let's just say they
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get Insurance On B.
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And B is a little bit riskier,
so they have to
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pay 200 basis points.
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200 basis points goes from
Pension Fund 2 to B.
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Now this, already, this is a
little bit dangerous, right?
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Because you can think about
what's happening.
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One, as long as this insurer
does not get a downgrade from
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their credit ratings from S&P
or Moody's or whoever, they
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can just keep it issuing
this insurance.
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There's no limit for how much
insurance they can issue.
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There's no law that says, you
know what, if you insure a
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billion dollars of debt,
you have to put a
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billion dollars aside.
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So that if that debt defaults,
you definitely have that
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billion dollars there.
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Or if you insure 2 billion here,
you don't have to put
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that 2 billion aside.
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What you have is a bunch of
people who statistically say,
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oh, you know, what's the
probability that all of this
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debt defaults?
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So I just have to keep enough
capital so that
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probabilistically, whatever debt
defaults, I can pay it.
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But you don't keep enough
capital to pay all of the
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defaulting debt.
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So you already see an
interesting risk forming.
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What if all of these
corporations, for whatever
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reason, do start defaulting
simultaneously?
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Then all of a sudden this
insurance company has to pay
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more out in insurance then it
might even have. So you have
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to wonder whether it even
deserves this Double A rating,
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because it actually is taking
on a lot of risk.
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But in the short term, while
these companies are-- everyone
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is doing well and the economy's
doing well, it's a
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great business for these guys.
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These guys are just collecting
premiums essentially on the
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insurance, without having
to pay out anything.
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Now let's add another
twist on it.
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These pension funds, P1 and P2,
it was reasonable for them
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to get insurance, because they
were giving out these loans
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and then they got
the insurance.
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So they were essentially hedging
the default risk by
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buying these credit default
swaps, which was essentially
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just an insurance policy
from this Insurer 1.
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But you can have
another party.
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This is no less legitimate,
really.
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But you could call them-- I
don't know-- let's call it
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Hedge Fund 1.
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And they've done a lot of work,
and frankly, they often
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are much more sophisticated
than the pension fund-- in
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fact, they almost always are.
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And they say, you know what?
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Company B looks really, really,
really, really shady.
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I think 200 basis points for
the chance that Company B
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defaults is frankly cheap.
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Because I think there's
a huge probability
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that Company B defaults.
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So what I'm going to do, I'm
not going to lend Company B
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money, because if anything, I
think that they're maybe about
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to go out of business.
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But what I can do is I can buy
a credit default swap on
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Company B's debt.
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Which is, essentially, I'm
getting insurance that they
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fail without actually
lending the money.
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So let's say I do that
from Insurer 2.
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So I can go and I'll pay Insurer
2 200 basis points a
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year, or 2% on the notional
value of the
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insurance I'm getting.
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So let's say it's 200 basis
points, and let's say that's
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Insurance On-- I'm making a big
bet-- so they're going to
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give me Insurance On B for--
I don't know-- $10 billion.
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And something interesting is
going on here already.
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B might not have even borrowed
$10 billion, right?
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So all of a sudden you have
this hedge fund that is
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getting insurance on more
debt than B has even
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borrowed money on, right?
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And it's essentially, you just
kind of have this side bet
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between these two parties.
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This party says,
you know what?
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I think it's a good deal.
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I get 200 basis points on the 10
billion every year, as long
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as B doesn't default.
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And this guy says, I think
B's going to default.
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So I think that's a good
deal on that insurance.
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And just so you understand the
math, so the notional value is
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$10 billion.
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So what's 2% of 10 billion?
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2% on a billion is 20 million,
so it's $200 million.
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200 if I did my math correct.
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So they'll pay $200 million
a year to this insurer.
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So the 200 basis points
on 10 billion is
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equal to 200 million.
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These numbers maybe are a little
bit on the big side,
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but who knows?
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Actually, this could be
a huge hedge fund.
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This could be a $10 billion
hedge fund.
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Or even worse, maybe it's a
billion dollar hedge fund, or
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maybe it's a $20 million hedge
fund, but they've taken a $180
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million loan to essentially
buy this insurance because
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they think that B's collapse
is imminent.
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So they're willing to take
that bet right now.
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You know, it might
be a good bet.
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If B collapses tomorrow,
what's going to happen?
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They only dished out maybe 200
million for maybe that first
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year, although you normally pay
it on a quarterly basis.
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So they'll pay 50 million
every three months.
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Let's say they pay the first
payment, 50 million, right?
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And then over the next three
months, B just goes bankrupt
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and people realize that debt
was worth nothing.
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Then these guys get
$10 billion.
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Right?
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But something else is
interesting here.
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They probably did insurance to
a lot of other people too,
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maybe on B's debt.
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Right?
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Or maybe they also
insured A's debt.
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So maybe they gave
some insurance on
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A's debt, as well.
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So what happens?
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Let's say B all of a
sudden defaults.
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So a couple of things happen.
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I1 is going to owe P2
$2 billion, right?
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I2, the second insurer, is going
to owe this hedge fund
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$10 billion.
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Now let's just assume I2's
good for the money.
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They have $10 billion they
pay to this hedge fund.
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This hedge fund is great, they
get great bonuses for the year
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and they go buy yachts,
et cetera.
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But this insurer right here,
they pay the money they were
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good for but something
interesting might happen.
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All of a sudden Moody's finally
wakes up, these
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ratings agencies, and
says, oh, my God.
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Well, there's a couple of things
that might make them
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say, oh, my God.
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First of all, they might
say, oh, look.
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You have to pay out
$10 billion.
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And I doubt that was the only
person you have to pay, maybe
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they have to pay out
a lot of money.
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Now I2, Insurance Company 2,
you are undercapitalized.
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I am now going to downgrade
your rating.
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So, you were Double A, but since
you had to give out all
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of this capital, Moody's is now
going to downgrade you to,
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I don't know, B+.
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I'm just making these
ratings up.
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But that's the sound of how
these ratings happen, right.
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A is better, B is worse.
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The more A's you have,
the better it is.
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But all of a sudden, when this
guy is B+, and this guy
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insured, let's say, some other
corporation's debt for this
[613]
pension fund, now all of a
sudden this insurance that
[616]
this pension fund had is no
longer Double A Insurance.
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It's now B+ Insurance, and maybe
this pension fund, by
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its charter, can't hold
something that
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has a B+ credit rating.
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So they're going to have to
unwind the transaction, or
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maybe they'll have to unload
the debt that was insured.
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So one, just by Company B
defaulting, maybe this guy was
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holding some of Company A's
debt, and it was insured by
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Insurance Company 1.
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Now they're going to have
to unload that debt.
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So just one default creates this
chain reaction, right?
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This one default happens, this
guy has to pay this guy money,
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then this guy gets
undercapitalized since they
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have to pay out money.
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Then Moody's says, oh, my God,
you're undercapitalized.
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We're going to reduce
your ratings.
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Maybe this guy was insuring
some of A's debt, but now
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since he was insuring some of
A's debt, all of a sudden that
[671]
insurance is worth less because
it has a lower rating.
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And now A's debt, less people
want to hold it, because there
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are less people to insure it.
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I know that's very confusing,
but this is really the point
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that Warren Buffett was saying
when he said that the credit
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defaults swap market, or in
general, the derivative
[689]
market, are financial weapons
of mass destruction.
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Because you have so many people
who didn't have to set
[695]
aside a capital, right?
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This guy could insure $10
billion worth of debt without
[699]
having to set aside
$10 billion.
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And you have so many people
making all of these side bets,
[704]
but they're all making
two core assumptions.
[706]
One, that these rating
agencies's ratings are valid.
[710]
And two, that the other person
is good for the money.
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But if all of a sudden you have
one failure someplace in
[715]
the system, you could have
this cascade where one,
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there's just a lot
of downgrades.
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And then a lot of the people
end up not being
[721]
good for the money.
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