If you’ve watched The Big Short, then you may believe you understand all there is to the last financial crisis. The movie was very good at explaining some of the financial assets that cause the Great Recession. By now the terms mortgage-backed security and CDO are easy to throw about, and if people start saying CDOs are about to burst again, you’ll be prepared right?

I thought that the movie missed one important part of the causes of the recession. The movie briefly covered credit default swaps, which it did in a short little clip at a blackjack table. The only other time the asset was referenced was in the beginning when Michael Burry is buying something from those bankers. What defined the scene was the banker’s incredulity that someone would offer them such a deal, but little was said about what was being offered. What Burry was buying, or rather selling, at that time was actually a CDS.

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The lack of coverage on credit default swaps is probably for two reasons. First, they are more complicated to understand in the grand scheme of the crash, and that ties into reason two, which is CDSs are not inherently a destructive tool, which CDOs are easily made out to be. This is because in simplest terms, CDSs are financial insurance plans.

It’s important to understand CDSs so that you can understand the rational aspects of the crash. Recessions like the one we just experienced don’t occur without some great shift in financial or economic markets. It’s not just that housing prices were growing too fast, or that financiers made highly risky leveraged products. It’s about knowing why these symptoms occurred in the first place. Once you understand CDSs you’ll understand why these symptoms occurred.

In other words, the question isn’t how institutions created all this debt, but why?

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The Holy Grail of Banking

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“Until recently, credit remained the major component of business risk for which no tailored risk management products existed. By separating specific aspects of credit risk from other risks, credit derivatives allow even the most illiquid credit exposures to be transferred to the most efficient holders of that risk.”

- From the JP Morgan “Guide to Credit Derivatives

.In 1993 the authors of the above publication were claiming that JP Morgan had created credit (loans) without risk. Banks would no longer face the uncertainty of defaults hurting their balance sheets. Credit derivatives claimed, by its namesake, that it was possible to hedge the risk of trusting another party. The majority of credit derivatives contracts are credit default swaps. Generally, swaps are a form of derivatives that allow two parties to exchange cash flows. This hedges risk to an extent, but is more of fine tuning tool that allows two parties at a time to tailor the type of risk they wish to be exposed to, rather than eliminating the risks.

Credit default swaps are an exchange between two parties of the risk of credit exposure. More officially, a credit default swap is a contract between two parties, where the buyer pays a regular fee to the seller of the contract, in exchange for the seller guaranteeing that the buyer will be compensated if a default occurs on the reference loan. Now the typical scenario is that a bank would be the party paying the regular fee, and some insurance company would be the one taking the default risk, if it occured. Otherwise, the insurer would make a steady stream profit. But in the Big Short, things were so messed up that Michael Burry decided to pay the bank to become the “insurance” company, and he would pay then to essentially insure their own products which the banks had been trying to get others to insure in the first place. This is like if you bought auto insurance, and then some guy on the street came and said, “Hey, I’ll pay you every day, but if you ever have an accident, you have to give me all the money the insurance company pays out.” And then you just say “Sure, I’m never going to get in an accident anyways.”

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So while this is quite similar to purchasing an insurance contract for a loan, credit default swaps clearly operate on a few different premises. First, credit default swaps are not part of the insurance market and so faced almost no regulation. Second, credit default swap contracts are not tied to any actual loans, they merely “reference” the underlying debt that is insured. Referencing is commonly depicted as such:

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The nature of referencing allows for credit default swap contracts to be freely traded, as a there are no assets fixed to the contract, while the contract itself is an asset. Credit default swaps have a market value that is determined by the likelihood that the reference entity will default in some manner, and buyers of credit default swaps can trade on that value. Additionally, because loans are only referenced, and no ownership is affected, two parties that have no physical ties to a certain loan can still make a CDS contract that references that loan. Because of this, an unlimited amount of CDS contracts can reference a single loan.

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Rule of Logs: CDS Growth

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How did the CDS market grow at such an enormous rate if every swap required two matching parties to be found and a mountain of legal work to be sorted? For a market to go from a few billion dollars to $14 trillion in outstanding value there must have been a way to create a highly commercially-viable structure to package these swaps. The inspiration for such a structure came from the world collateralized debt obligations. As Tett reports (2009, 51), bankers at JP Morgan realized that securities could be backed by the stream of payments a buyer of credit default swaps would pay for default protection, and the value of these payments could be arranged into a tranche structure for added investment precision. By pooling reference entities, creating tranches in the stream of payments, and then issuing securities backed by the payments to outside insurers, entire balance sheets of loans could be insured from credit risk with a single issue of securities.

The JP Morgan creators originally called these securities backed by credit default swaps BISTRO offerings (Tett, 2009, 57). In these deals, a bank would pool all of the fees that it would have to pay for each individual credit default swap, create artificial divisions of risk by giving the tranches with a seniority payment order, and then offer securities that would transfer the bank’s credit default swap payments to the investors in the different tranches of securities, with the return determined by the risk level associated with each tranche. The investors, in exchange, would then have to pay for any defaults on the loans, taken from the “collateral” they paid for the securities. These BISTRO structures would become known as synthetic collateralized debt obligations, as they were not really backed by any assets since the loans that were insured still belonged to JP Morgan. In the first commercial scale BISTRO sale that JP Morgan conducted in 1997, the firm insured $9.7 billion of credit risk by issuing $700 million dollars of securities (Tett, 2009 60-65), eliminating $10 billion of credit exposure. This was the same credit exposure that factored into the firm’s limits on the amount of loans that could be made, into the amount of capital reserves that the bank needed to post to cover its operations, and into the total risk exposure of the firm.

In short, credit default swaps were the greatest financial innovation to occur since banking itself, or at least it seemed that way before the Great Recession. Credit default swaps enabled banks to make loans and service those loans without needing to worry about any of the negatives involved with making extending credit. As far as the firm was concerned, by insuring the risk of default, there were no other significant risks that needed to be considered. If a loan was defaulted on, high-risk investors would pay the costs of default, in exchange for receiving a stream of payment if no defaults occurred. Credit default swaps in a sense were CDOs without the moral hazard of banks simply passing all the risk off. Banks still had to care about the loans they were making, these loans remained on their books and the borrowers were their customers. However, taking losses from defaults in the loan portfolio would be a thing of the past… as long the loan pools truly were diversified. And while this logic may not have proven true, the credit derivatives market weathered the dotcom bubble admirably, enough that banks had full confidence in buying $16 trillion worth of CDSs during the heart of the subprime lending boom.

Credit derivatives changed the way the credit cycle operated by creating the illusion of a permanent upturn in the credit cycle, and it was not just the banks who believed in this. Government officials, policy economists and regulators all bought into the dream of riskless credit. Hedge fund managers and other less speculative money managers bought even the riskiest debt assets banks were cooking up, since everyone knew that the risks of default were gone. And American consumers, believing that all the prosperity around them would last forever just like the financial world was claiming, took on $14 trillion worth of debt.

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Profits for Everyone!

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Soon banks were making record revenues, and creating riskier and riskier assets to push their wealth higher and faster. They created complicated derivatives of derivatives, created shell organizations to load and load on risk and hide losses. And eventually they pushed too hard, and their Holy Grail turned to dust.

And around this point, the events from “The Big Short” begins.

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