[Song Seungseop's Financial Light] The Magic of 'CDS'... I'll Pay the Premium, You Take the Default Risk

90s JP Morgan's First Agreement with European Investment Bank
Paying Fees to Avoid Default Risk and Strengthen 'Safety'
Financial Firms Discover New Revenue Sources and Prefer CDS
Speculative CDS Also Triggered Global Financial Crisis

Editor's NoteFinance is difficult. Confusing terms and complex backstories are intertwined. Sometimes, you need to learn dozens of concepts just to understand a single word. Yet, finance is important. To understand the philosophy of fund management and consistently follow the flow of money, a foundation of financial knowledge is essential. Therefore, Asia Economy selects one financial issue each week and explains it in very simple terms. Even if you know nothing about finance, you can immediately understand these 'light' stories that illuminate your understanding of finance.

[Asia Economy Reporter Song Seung-seop] "The average Credit Default Swap (CDS) premium of domestic financial holding companies has risen to 75bp, three times higher than at the end of last year," "The announcement of the call option exercise by Heungkuk Life Insurance has reduced Korea's CDS premium." Recently, the term CDS has appeared frequently in newspapers. CDS, one of the derivatives, is a very important concept that cannot be omitted when discussing the credit of countries and companies. What is CDS, and how did it come about?

CDS stands for 'Credit Default Swap.' In Korean, it is called 신용부도스와프 (Shinyong Budo Swap), which literally means swapping credit and default. Suppose you lent 100 million won to Mr. A. You would worry whether A can repay the 100 million won properly or if he might default. So, you approach Bank B and propose, "If A fails to repay, please pay on my behalf. I will pay you a fee of 100,000 won every month." Mr. A's default worries are eased, and the bank earns a monthly fee of 100,000 won.

'CDS' Developed by JP Morgan in the 1990s

JPMorgan headquarters
[Image source=Reuters Yonhap News]

This CDS was first developed in the 1990s by JP Morgan Chase, a major American investment bank. In 1994, JP Morgan lent a large sum to the oil company ExxonMobil. At that time, ExxonMobil was facing financial difficulties due to the Alaska oil spill accident. If ExxonMobil defaulted, JP Morgan would be unable to recover the money. So, JP Morgan made a CDS contract with the European Bank for Reconstruction and Development (EBRD). The contract stipulated that if ExxonMobil defaulted, EBRD would pay the money on its behalf. In return, JP Morgan paid a certain fee to EBRD.

Whether you lent money to Mr. A or JP Morgan lent to ExxonMobil, both paid fees to enhance safety. Therefore, the party paying the fee in a CDS contract is called the 'protection buyer' or 'risk seller' because they sell the default risk to another party (the bank). Conversely, the bank that receives the fee and assumes the default risk is called the 'protection seller' (risk buyer). This means giving up safety and taking on risk. The fee exchanged between them is called the 'CDS premium.'

The protection seller (risk buyer) is usually a financial institution like a bank because they have large funds, high credit, and are safe. However, banks do not accept CDS premiums arbitrarily. What happens if the loan is to a financially weak or low credit rating company? Since the likelihood of default is high, the CDS premium is set high. Conversely, if the loan is to a strong and sound company, the CDS premium will be low. Therefore, the CDS premium is an important indicator for assessing companies or countries. A high premium means a high risk of default, and a low premium means a low risk of default.

CDS Developed Like Insurance, Used for Investment

A representative example is when the U.S. federal government faced a shutdown crisis in 2013 due to failure to agree on the budget. At that time, the 5-year CDS premium of the U.S. reached 36bp, the highest in six months. As concerns grew that the U.S. might fail to repay properly, the related CDS premium rose. Recently in Korea, the CDS of the domestic financial market surged significantly due to Heungkuk Life Insurance's non-exercise of the call option on new capital securities. This indicates that the financial market was shaken. However, when Heungkuk Life announced the exercise of the call option, the soaring CDS premium fell.

Up to this point, CDS seems like a very rational financial product. Although a derivative, it feels like a kind of guarantee insurance product. You pay a premium (CDS premium) just in case, and if an accident occurs (company default), you receive insurance money (loan principal). When JP Morgan first developed the product, CDS was used like guarantee insurance. The purpose was strongly to diversify the risk of held assets.

However, there is one important difference between CDS and guarantee insurance. In guarantee insurance, the contracting parties must exchange actual bonds. They directly lend money and provide guarantees, exchanging the 'right to receive money.' But CDS is different. CDS can be traded without exchanging bonds. In other words, 'even if you have never lent money, you can enter into a CDS contract with a bank targeting a specific company.' If you think a particular company might become insolvent, you enter into a CDS contract with a bank and continuously pay fees. You are betting on the company's bankruptcy. If the company actually defaults, you receive the promised money from the bank.

The Tragedy of the Financial Crisis Caused by CDS

Wall Street Sign

This type of CDS is called 'naked CDS.' Naked CDS allows people who have not lent money to participate, which increases market liquidity. On the other hand, it also encourages dangerous speculation. It is a financial product where you invest a small amount of money in CDS premiums and make large profits through the bankruptcy of a specific company. Moreover, if naked CDS grows, the market becomes distorted. If naked CDS related to Company A increases, people may misunderstand that 'Company A's bankruptcy risk is high.' This can cause investor fear and lead to a crash in Company A's stock and bond prices.

CDS has also caused the collapse of the global economy. The 2008 global financial crisis is an example. At that time, financial institutions on Wall Street were the risk buyers for loans given to homebuyers. If the mortgage borrowers failed to repay, the banks promised to pay on their behalf. In return, banks received premiums from the financial institutions that issued the mortgages. Since housing prices were continuously rising, banks believed mortgage borrowers would never default.

From 1998 to 2008, CDS grew more than 100 times. In November 2008, CDS reached $33 to $47 trillion, exceeding twice the U.S. Gross Domestic Product (GDP). When many mortgage borrowers failed to repay debts, banks could not handle the CDS they had recklessly purchased and began to go bankrupt. The U.S. financial crisis spread worldwide. This led to public opinion calling for regulation of CDS globally.

This content was produced with the assistance of AI translation services.