Stuff You Should Know - How do credit default swaps work?

Episode Date: April 30, 2009

In theory, credit default swaps are simply insurance against failed investments. In reality, these swaps can quickly get complicated. Tune in to this podcast from HowStuffWorks.com to hear Josh and Chuck demystify credit default swaps. Learn more about your ad-choices at https://www.iheartpodcastnetwork.comSee omnystudio.com/listener for privacy information.

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to wander. Plan your next dining adventure at visitmississippi.org slash dining. Mississippi. Wanderers, welcome. Brought to you by the reinvented 2012 Camry. It's ready. Are you? Welcome to Stuff You Should Know from HowStuffWorks.com. Hey and welcome to the podcast. I'm Josh Clark and guess who's with me? Mm, Ronald McDonald. Yes. I met Ronald McDonald at my cousin's 15th birthday party. Really? Yeah, he's pretty cool. No, weird. That's the first thing that came into my head. I guess I mean, I'm hungry. I guess so. Are you hungry? Did you eat today? No. This is going to be a fun one, Chuck. We're talking about credit default swaps. I know. I know. We're going to try to make it sexy.

Yes. Should I go ahead and give the caveat here? If you want, go ahead. 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. It's pretty thick, Chuck. Might be a little different today. Josh is going to be teaching me along with you. Okay. Are you prepared? As prepared as I can. I appreciate you dressing like a little school girl today to really kind of complete everything and round it out. Yeah. Okay, so well, let me give you an analogy. All right. Okay. So Chuck, imagine if I went to your health insurance provider, right? Yeah. And said, Hey, I want to buy Chuck's policy. Okay. And they said,

okay. And they sold it to me. And you would be in charge of that policy. I would own the policy. So I'd be, I'd 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. Right. But if you did get into an accident, I would be on the hook to pay your medical expenses, right? You bet you would be. You and I are both fully aware that I don't have the money to pay your medical expenses. No. So basically what would happen is I'd pay as much as I could until I bankrupted myself. Right. And then you'd be on the hook to pay your medical expenses. Right. Okay. I get that. So you'd be in trouble. It bankrupt you and we'd both be up the creek.

I understand. So are you with me so far? Yeah, that makes sense. Now imagine if you owned two other people's life or health insurance policies. Okay. Just like I owned yours. Okay. Sure. Now let's say you, that accident you got into was a three car pile up, just in a mind boggling coincidence with the other two people whose health insurance policies you owned. Okay. I'm with you. 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's. So imagine if this just keeps going on and on and on and on in this infinite car pile up and everybody owns everybody else's insurance policy,

but nobody can pay. Okay. Okay. That's awful. It seems, it does, it is awful. It's kind of nightmarish, right? It is. So the good thing is this can't happen because health insurance is a heavily regulated industry. Right. 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. Right. Do they do that? Yeah. Yeah. And what's more, they can't sell your insurance policy to anybody. Right. Okay. Right. With credit default swaps, all the, 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. Okay. This is where I start to get a little

fuzzy. I understand. It does get a little fuzzy at this point. It's a bit of a abstract. It's a bit abstract for me. 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. Okay. But you don't have to be evil to describe them to people in podcast land. No, no, you just have to read them. Read the article several times and write it to it. Doesn't hurt to write it. I read it several times and it was still a little bit. Maybe you have to write it, writing it out. Okay. 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. It's a derivative. It is a derivative

and a derivative is a derivative. I do know this. It's a financial instrument that has a value based on the value of another financial instrument. 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, right? With this, this would be based on future in oil future, right? So it doesn't have its own value. It's values 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, right? Sure. And so you'd be getting the oil, cheaper oil for them, what you paid for it. You would, you would lose money, right? 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. Okay. So it's like insurance? That's exactly what it is. Okay. So in the 90s, they started issuing these things on municipal bonds, which are about as safe as it gets. Almost every city except for probably Detroit has a AAA credit rating, right? Right. 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. Right. And a city can tax its citizens to pay off its debts, which is one of the reasons why they're so stable, okay, and reliable and credit worthy, right? Gotcha. So the thing is, like all these banks that are issuing these policies are saying, you know what, we're making just tons of extra income because they're, 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, there's no default on the loan. Right. And so the banks are just raking in extra money. So these things started to take off like a rocket. Who's the day? That's what I'm confused about. That's the bank. They actually issue these. Okay. So let's say, let's say that I have a bunch of money and Atlanta needs to repay 400. Okay. 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 and return to hang on to earn like slow, steady, small interest, right? I would buy a credit default swap from a bank, right? Okay. To say if this city doesn't pay me

back, then I can cash in this credit default swap, this insurance policy against the, against the, the loan I gave the city. Okay. Okay. And then I'll actually make more money because like a life insurance policy, it has, it's worth more than say the actual loan. Okay. See, coming into focus. Okay. Is it, is it? Yeah. Yeah. Okay. Good. We should, we should talk together before we do these. I've ruined everything. Yeah, I guess you're right. Yeah. So, okay. So the, so the, it made a huge source of extra income for the banks that were issuing these, these insurance policies. Right. Because no municipality was defaulting on their loans. Right. Yeah. So they started to look for other places where they could sell these things or people they could sell them to. Of course.

And essentially you can cover any debt whatsoever with a credit default swap. Well, that's amazing to me. And I think one of the reasons why it was able to take, to take off like this is because they're unregulated. It seems like the, you know, 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? They're wholly and completely to this day unregulated. It's amazing. So, which is why that, that scenario that I gave you at the beginning about your health insurance policy, right? That's dead on with credit default swaps. So think about this. Say a bank issues a credit default obligation to somebody who has created debt, right? Right. That guy who loaned money to the city for that road project.

Sure. Okay. So he buys a credit default swap. Now there's two players in this one. Really, as far as the insurance policy goes, you get the bank who has the issuers side of it. Right. And then you've got me, the guy who made the loan to the city who has the buyer side of it. Right. And do you pay a premium? Like, yeah, like an insurance. Right. And then both of these 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. Really? What's more, because it's unregulated, if the bank sells it to you, right? 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. Right.

If that, if the city defaults on the loan. This sounds two things. This strikes me. It sounds like La La Land. And it sounds like a really bad idea. It is because Chuck, here's the problem. Right. If you, if we haven't come up with enough problems yet, since it's also since it's 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. Sure. One of them is if the city just says we're not repaying your loan, that would be a credit event, right? Right. And then that triggers payment. Problem is, is since they're unregulated, anybody can dispute whether or not a credit event 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. Well, who did they dispute it to though, since there's no body? They take the other person to court. Oh, they just start suing each other. Yes. More litigation. That's exactly what we need. Right. The thing is, it's, it's still, like I said, to the state unregulated. There is actually an independent body of banks and investment houses and other, other investors and securities analysts, I believe, who have come together to form an arbitrating panel for credit default swaps. That's a good thing, right? It is a good thing. But again, it exists outside of the government. Right. Right. So everybody who's involved in the credit default market had to agree, yes, we'll listen to these people.

Their decision is binding. But is that, I mean, existing outside the government, isn't necessarily a bad thing? No, it isn't. But I think to me, it's just kind of one more point, like, where's the SEC? Right. 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. So that's the problem with it being unregulated, right? Well, it sounds like it's right for a nightmare scenario, too, like you first were talking about. Let me, let me set the stage for you. Okay. Okay. In July, 2007, you remember the good, heady days of the bubble before it burst? Oh, yeah. Okay. In 1980, cocaine was captivating

and corrupting Miami. Miami had become the murder capital of the United States. They were making millions of dollars. I would categorize it as the Wild Wild West. Unleashing a wave of violence. My God, talk about walking into the devil's den. The car kills. They just killed everybody that was home. They start pulling out pictures of Clay Williams' body taken out in the Everglades. A world orbiting around a mysterious man with a controversial claim. This drug pilot, by the name of Lamar Chester, he never ran anything but grass until I turned over that load of coke to him on the island. Chester would claim he did it all for the CIA. Pulling many into a sprawling federal investigation. So, Clay wasn't the only person who was murdered?

Oh, no, not by a long shot. I'm Lauren Bright Pacheco. Join me for Murder in Miami. Listen to Murder in Miami on the I Heart Radio app, Apple Podcasts, or wherever you get your podcasts. In 1968, five black girls dressed in oversized military fatigues were picked up by the police in Montgomery, Alabama. I was tired and just didn't want to take it anymore. The girls had run away from a reform school called the Alabama Industrial School for Negro Children, and they were determined to tell someone about the abuse they'd suffered there. Picture the worst environment for children that you possibly can. I believe Mt. Mays was patterned after slavery. I didn't understand why I had to go through

what I was going through and for what. I'm writer and reporter Josie Duffy Rice, and in a new podcast, I investigate how this reform school went from being a safe haven for black kids to a nightmare, and how those five black girls changed everything. All that on Unreformed. Listen to Unreformed on the I Heart Radio app, Apple Podcasts, or wherever you get your podcasts. The subprime mortgage market was valued at, let's see, I think $7 trillion in the U.S. In the U.S. alone. In the U.S. But the U.S. is, I think, the biggest player in the subprime mortgage market, right? Oh, sure. 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?

I do, but I'm going to let you say it. Are you ready? Yeah. $62 trillion. That's unbelievable. Do you know what the global GDP was for 2008? I do, but I'm going to let you say it. You're ready? Yeah. $69 trillion. Wow. So it's just short of the global GDP. So basically, if every country in the entire world could suddenly sell off everything they produce, every good and service it produced in a year to say some aliens, right? We'd still just, we'd have like $5 trillion left over for the year. It sounds like this is the biggest market of anything in the world, almost. Yes. I think so. I can't think of anything that's valued at more than that. And just think about it. This is the late 90s. So in a decade, this unregulated market went from zero to 62 trillion.

Well, what's amazing is, like you referenced is the mortgage crisis. And that's a scenario you can, you can track it down to a house eventually, like a physical property. But this is sort of like exist in the ether. So where there's no end of the line. No, it seems like. No, there isn't. Which is why you can say, nah, credit, 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, I can't pay you. You know, I can't pay you the money that I owe you, right? So what is this latest? Well, hold on. Let me say one more thing. The whole reason this market blew up was because

it's actually a way to bet on the health of a company, right? 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's going to go under because they're paying monthly premiums, but it's on the premise that you that that company's going to go under and there'll be a much bigger payout. Right. You can do those stocks too. Yes. Even more, you can actually short sell a company driving its value down. If you own enough shares or 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. That seems unbelievable. Okay. So this is

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. Really? This huge domino effect was triggered. A bunch of people had credit default swaps on the subprime mortgage securities that they owned, right? Oops. Oops, indeed. So when the subprime mortgage securities went south, everybody turned to their credit default swaps and went, 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, 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's no credit default swap to cover or can't be covered, then that's when your balance sheet goes into, I'm sorry, into the red. Right. Right. Which is the bad one. Right, right. Yeah, I get that. Okay. So that's what happened with Lehman Brothers. That's why AIG got all of that bailout money. Right. Because they had a bunch of credit default swaps. And now there's this panel that I talked about, the independent panel that's actually gotten the value of the market down to

about 25 trillion. I wonder how independent they are. Well, yeah, I think it's probably all revolving doors stuff. Like if they haven't held public office in the last couple years, they will. But they'll work for Goldman Sachs. I think Goldman Sachs is a major player in that panel. Yeah. In 1980, cocaine was captivating and corrupting Miami. Miami had become the murder capital of the United States. They were making millions of dollars. I would categorize it as the Wild Wild West. Unleashing a wave of violence. My God, talk about walking into the devil's den. The carcels, they just killed everybody that was home. They start pulling out pictures of Clay Williams body taken out in the Everglades. A world orbiting around a mysterious

man with a controversial claim. This drug pilot by the name of Lamar Chester, he never ran anything but grass until I turned over that load of coke to him on the island. Chester would claim he did it all for the CIA, pulling many into a sprawling federal investigation. So Clay wasn't the only person who was murdered. I'm Lauren Bright Pacheco. Join me for murder in Miami. Listen to murder in Miami on the I Heart Radio app, Apple podcasts, or wherever you get your podcasts. In 1968, five black girls dressed in oversized military fatigues were picked up by the police in Montgomery, Alabama. I was tired and just didn't want to take it anymore. The girls had run away from a reform school called the Alabama Industrial School for Negro children, and they were determined

to tell someone about the abuse they'd suffered there. Picture the worst environment for children that you possibly can. I believe Mt. Mays was patterned after slavery. I didn't understand why I had to go through what I was going through and for what. I'm writer and reporter, Josie Duffy Rice, and in a new podcast, I investigate how this reform school went from being a safe haven for black kids to a nightmare, and how those five black girls changed everything. All that on unreformed. Listen to unreformed on the I Heart Radio app, Apple podcasts, or wherever you get your podcasts. Well, this sounds like I get it now. Do you really? Yeah. Yeah. Yeah. All right. So thanks for that. But thank you. Where does this lead? I mean, is this something's got to happen at some

point, it seems like, or else it's setting us up for even more failure economically, right? Right. No, no, no. Most definitely. I think it's just, it seems like the credit default swaps market is being tamed. Like I said, we've gone from 62 trillion to 25 trillion in just like two years. Okay, that's good. But I think it's symptomatic of the lack of regulation and oversight that we've had. Right. I mean, 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, right? You know, and then the fact that there's hole over the counter markets that are allowed to get this big without any regulation whatsoever. I think it seems 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? Right. 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, you know, pro-business people always say, you know, 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? Yeah, yeah. Which means that no matter how many roadblocks the government throws up, all it's doing is presenting challenges for very clever people. And they'll always find a loop

hole. Oh yeah, always. Yeah. 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. Right. Well, when you're talking now $25 trillion that's still such a massive amount that it's kind of frightening to think about. It is, but it's doable. It is. I think if the U.S., Japan, and the U.K. got together and sold everything off in a fire sale, we could cover it. Right. Yeah. Yeah. All right. Well, I get it. Thanks. Good. I'm feeling pretty good about myself. Well, you should. Credit default swaps a hoi. Yeah. This, this was sort of like some math kind of 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. Yeah. I'm like that with algebra. Really? I get geometry, but not algebra. We should do a podcast on it and fumble our way through that. Yeah. Yeah. So there, there you have it. Awesome. All right. Are we still plugging things anymore? Sure, Josh. We'll just give a quicky plug to the blog. All right, blog stuff. You should know blog that we write once a day each. And it's on the right side of the homepage. Very nice. And it's been enjoyable. And that's all we need to say. Yes. That is it. So then what does that mean, Chuck? It's listener mail time. It is indeed. And Josh, this one, I'm really looking forward to reading. Which one is it? This is the I, me incident. We get a lot of these. For those of you, obviously you don't know because you don't

get a listener mail. We have a lot of people that take us to task on the use of I and me, Josh and I, Josh and me, me and Josh, I and Josh. I seem to get it a lot more than you though. Oh, we both do. Do we? Yeah. So people take us to task and tell us that we're not being responsible with our grammar. And I got this email from Keith in Alton, Illinois. And Keith says, I just want to let you know that as a student of linguistics, I like to tell you that in a compound object, e.g., send listener mail to Chuck and I slash 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. Awesome, Keith. 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. Steven Pinker, really? Yeah. Okay. Do you know him? I just heard of him last night for the first time. Really? Yeah, it's odd. How about that? So the last sentence of his thing says, by the logic of grammar, the pronoun is free to have any case it wants. I agree. I think the point of communication is to get your idea across to

somebody. Exactly. And I think interchanging I or me still gets the point across. Yeah. I think if you can get your point across with grunts and hand gestures, that's proper communication. Right. And when it comes down to it, the name of this show is not grammar you should know. Right. And we're always the first ones to say we're not, you know, we're not perfect. So lay off. Yeah. 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. Yeah, Keith, shirt size and address. And well, thank you for having our backs on this. 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, well, whatever, how about we

rerecord that part? So if you want to have our backs or you want to take us to task like the grammar Nazis that wrote in, just go ahead and send us an email to stuffpodcast at howstuffworks.com. For more on this and thousands of other topics, visit howstuffworks.com. Brought to you by the reinvented 2012 Camry. It's ready. Are you? The war on drugs is the excuse our government uses to get away with absolutely insane stuff. Stuff that'll piss you off the cops. Are they just like looting? Are they just like pillaging? They just have way better names for what they call like what we would call a jack move or being robbed. They call civil acid. Be sure to listen to the war on drugs on the iHeart radio app,

Apple podcast or wherever you get your podcast. On the new podcast, The Turning Room of Mirrors, we look beneath the delicate veneer of American ballet and the culture formed by its most influential figure, George Balangene. He used to say, what are you looking at, dear? You can't see you. Only I can see you. What you're doing is larger than yourself, almost like a religion. Like he was a God. Listen to The Turning Room of Mirrors on the iHeart radio app, Apple podcasts or wherever you get your podcasts.