Credit default swaps (CDS) - What are they and should investors be worried about them?

they've been called financial weapons of mass destruction by no less than Warren Buffett the famous US investor politicians in Europe seem to be obsessed with trying to ban them in some way they certainly like to criticize them and every time you hear the word Greece you'll hear the word c.d.s not far behind it so what are they and actually should investors worry as much as some people would have them worried so credit default swaps this video is going to look at what they are who uses them how they're priced and what that can tell you about the chances of say a country or a company going bust without worrying too much about the technical details we'll leave those to the eggheads so on this guided tour we're looking at what credit default swaps basically are what they do and also rounding up on should investors panic perhaps as much as the politicians okay so let's have a look at one let's take a look at this thing called the credit default swap that's way the thing about it is as an insurance policy planet to Volks WAP CDs the title sounds rather grand but think of it as insurance on investments so you and I might buy insurance for a car buy an upfront premium in return for compensation if something goes wrong in the investing world big institutions rather than you are I can insure their bond portfolios what do they want to insure against the risk that the issuer the person who sold them the IOU if you like goes bust and that's where CD s is come in so typical scenario you've got an investor now an investor could be an institution a fund manager of some sort and they've gone out and they've bought a portfolio of bonds now there are other videos on bond basics so I won't cover them again here but do take a look at that other video if you're not sure but a bond is essentially I owe you issued by a company or a government and obviously a lot of the Greek media coverage the moment is talking about what I called sovereign bonds that's io u--'s issued by the Greek government why because they needed to borrow money so institutions in the financial markets were prepared to lend them that money by buying it their bonds so far so good okay so where does the CD s come in well there are two risks with something like a bond or a share or any kind of investment really number one it can go down as well as up this price risk C DSU's don't do anything about that however C D s is like insurance policies on cars do something about the catastrophe the default risk okay think about it when you insure a car the value could go down or up and you may never need to claim on the policy the insurance policies are relevant to what you sell the car for in one sense same with CTS's they're designed to protect against some kind of catastrophe what would that be in the bond market it will be an issuer for example going bust so where's the CD s fit in basically let's bring in another player an investment bank and basically the nervous investor the investor has got these bonds is thinking well I suppose I could dump them all but realistically who's going to buy them besides which I don't really want to dump all my bonds because they pay an income stream a coupon so maybe dumping them wouldn't be that sensible because what would I replace them with cash so but also if I sell my bonds some of them might even trigger a kind of capital gain of some sort so really the tax purposes maybe I I want to hang on to them so as an investor in bond you might be sitting there thinking well for various reasons I'm happy to hang on to the bottom so I may feel I have no choice but hang on to the bonds and I want some kind of insurance policy so the credit default swap would work something like this the investment bank says right okay here's the deal this is a kind of insurance policy if you like so you pay us a premium which you're not going to get back now the investor is going to be paying this maybe upfront but more typically it's paid sort of in installment the kind of pay-as-you-go basis maybe over say five years and in return we'll offer you some form of protection if and here's a piece of jargon you see in the press a lot at the moment there is a credit event now we'll talk more about that what that might be in just a moment that is quite a SCADA source of debate right now what are these credit events that could trigger a payout by the investment bank that sold the insurance policy so in simple terms a CD S is bought by someone looking for protection against in this case bonds a portfolio of bonds and sold by an insurer you'd call it for cars but we'll call it an investment bank someone willing to sell protection and what is the protection well that can work in several ways if a credit event takes place what the investment bank might do is say to the the buyer of insurance policy I will take off or take all the bonds off you now what's called their normal value so I'll sort of guarantee a price for those bonds in effect and again normal value is something I talk about more in my bond basics video anyone not sure about that then effect in effect the bank saying I'll give you a sort of guaranteed value for those bonds and you just give me whatever they're worth when the credit event takes place now given that a creditor then is some kind of default it's bad news chances are they're not worth very much at that point so it is an insurance policy without games the technical details the investment bank is saying more payout if a credit event takes place and take those dodgy bonds off your hands okay and will compensate you for them so like all insurance policies the issuer would like to just collect the premium and frankly not have to worry just go out to lunch like your car insurance car and just pay a premium and then they've done something for almost nothing the investor would probably prefer not to have to claim on the policy but if a credit event takes place they may need to so the next issue what is a credit event that's a good question and there's much debate about this around Greece bonds at the moment or Greek bonds Greek sovereign bonds at the moment typically an easy credit event would be a default of some sort and so for example one of these bonds suddenly doesn't pay its coupon or worse it gets to the redemption date and the issue is simply can't afford to pay it back so a default or the issuer just goes bust and all of its bonds become suddenly under threat so most people would understand that one but it can get more complicated because credit events can also cover restructuring and that's where there's a bit of debate at the moment in the Greek market um so for example if a lot of Greek bondholders are thinking well these Greeks are not going to pay us back on time they just can't afford to the government can't afford to pay back on time maybe what we'll agree to do voluntarily as investors is essentially roll over our investment in the doggy bonds issued by the Greek government into less dodgy bonds issued by the Greek government what's longer maturities on question that's being debate at the moment which I don't have an answer to is would such a restructuring a voluntary restructuring constitute credit credit event that triggers loads of insurance payments on the credit default swaps or not and that's an issue you'll see debated around Europe just now okay what can credit default swaps tell you about what's going on in the market and the answer is they can give you quite a good insight into what the market thinks about the chances of say an issuer or an entire country going bust so let's take a quick look at pricing next now the detail of credit default swap pricing is quite technical but the basic principles are not first of all that's one thing you need to know in order to understand the price CES and read something into it which is the market likes basis points in other words you get credit default swaps quoted as 50 basis points or a thousand basis points you might think was that I mean normally an insurance policy is quoted as pounds or basically you can turn basis points into pounds or dollars more likely because one basis point is 1/100 of 1% okay so on that basis and 100 basis points is 1% and 50 basis points here's half a percent so if someone what someone were to say right how much is this credit defaults what the answer might be 50 basis points and what would that mean that would give you an indication of the sort of annual fee that the buyers got to pay the seller and the way it's expressed is a percentage of the amount of insurance cover if you like so what that means is imagine you take a contract which covers a notional amount of 10 million US dollars of bonds otherwise it's insurance on 10 million dollars nominal values is called of bonds and the price is quoted as 50 basis points let's get a higher this number the more expensive the insurance is how does that work out well we said but basically 50 basis points on this basis for one basis points 101 percent is half a percent if you take half a percent of 10 million you get 50,000 US dollars so what we're saying in effect is that that CD s is going to cost you $50,000 a year at a price of 50 basis points to provide insurance on 10 million US dollars of bonds so the higher the basis point quote the more expensive the insurance now these are figures are just plucked out of the air so what actually does it cost at the moment to insure Greek debt well to give you an idea just before Lehman Brothers went bust the cost of insuring its debt if you held it and wanted insurance was around fourteen hundred basis points so that's rather a lot higher okay than the 50 example I've got here so that whacks up the premium all right if you're still talking about 10 million dollars worth of bonds being insured a premium of fourteen hundred basis points would translate into one point four million dollars rather than just the 50 thousand I mentioned there what about Greek Portuguese and Spanish debt right now well let's have a look at some prices currently the cost of insuring Greek debt is in excess of 2,000 basis points right another way of looking at that is you are paying as a premium annually one-fifth of the value of the debt in question so another way of looking at that is the market is effectively giving the chance of Greeks going bust within five years over eighty percent probability another way of looking at that um who else is the market worried about well that's Greece here are some other numbers 850 basis points that's Portugal so again it's cheaper to insure Portuguese than Greek okay but these numbers have been creeping up the whole time there is an index the look to the circles of the cost of European debt insurance using CD s's and it's gradually creeping up and up and up look at another couple of countries on the sort of the hit list if you like for Spain at the moment the numbers around 300 basis points and on the sick list you've got Italy around the 220 mark now what exactly that means in dollar terms is that important that the principle that Greece is obviously well up at the top of the the sort of critical list at the moment followed by Portugal followed by Spain Follette basically now you'd have to agree you have to agree with the CD s market's view of who's most likely to go bust the CD s prices can give you a bit of an insight into what the market thinks might happen next now next question politicians and we'll finish on this one politicians are been talking about here banning speculators banning CBS's warren buffett called credit derivatives and these are example financial weapons of mass destruction you know how much trouble are they and the answer is really politicians are in one way using the magazine as an easy scapegoat they're saying here's this mysterious instrument with a weird sounding name that no one fully understands so we'll blame that all right rather than the fact that Greeks might've ever borrowed overspend and gone bust that way in other words the politicians will always look for somebody to pin the blame on when actually the blame might lie with them all the people they represent so is it right all these people saying we should ban CVS's well in Greek term CTS's are not that important in many ways now the problem with the market is it's difficult to get information these are private over-the-counter deals between large institutions they're kind of shadowy they're kind of hidden in the wings so it's quite difficult to get raw accurate data on how many of these things there are out there especially when you get into kind of market for corporate insurance well nonetheless the DTCC in the u.s. the big clearing organizations had a go and it said that really the CD s market in Greek times is quite small total outstanding insurance if you like on Greek debt fire CD s is around four point eight billion US dollars in a market for Greek bonds government bonds worth half a trillion okay so on that basis you're talking about quite a small market so with banning it make much difference and secondly do speculators really cause the problem there are some people around who would say that actually if speculators have been allowed to operate more effectively earlier on if shrink selling hadn't been banned for example effectively speculators could have driven up the cost of Greek debt much quicker that would have forced the Greek government to rein in spending much earlier because it couldn't have borrowed on such competitive terms and that would have forced all the current crisis in other words the market a crisis but it would have happened earlier and it would have been smaller so far from banning this speculation if CD s is are indeed purely speculative instruments we should perhaps have even encouraged it so if I'm going to criticize the CD s market it's not going to be for causing the Greek crisis that's a daft argument it's not even going to be for exacerbating it particularly and certainly all this debate about you know should a credit event be defined as bonds being rolled over a restructure that gets a bit technical a bit quickly essentially if these contracts are declared in default then of course there will be big payouts from one investment bank to to another or those from sellers to buy it but the point is that really to blame the CD s market for what's happening in Europe moment is really probably to find a sort of scapegoat but the problem the CDs market has and it's its own fault it is quite murky it's quite shadowy it's been labeled part of these financial weapons of mass destruction so a little more clarity the ability for investors to shine a torch into it would actually now probably help the market and perhaps remove some of the accusations that are flying about what it does and exactly what is responsible for

Channel: moneycontent

Views: 197,857

Rating: 4.8868966 out of 5

Keywords: educational, cfds, finance, investment, insurance, credit, city

Id: mZC6WCE5Bj4

Length: 17min 8sec (1028 seconds)

Published: Fri Jul 08 2011