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The First Credit Default Swap

Nov 28, 2011 • 288 Views

Some of the euro zone’s problems actually started with the Exxon Valdez oil spill.

After the 1989 Exxon Valdez calamity, when an Alaska jury said that Exxon owed $5 billion in damages, they asked J.P. Morgan for a $4.8 billion line of credit. Concerned about so large a loan, J.P. Morgan wanted to protect itself.

So, they invented the credit default swap in 1994 at a J.P. Morgan “team-building” weekend in Boca Raton, Florida. A new kind of insurance, the credit default swap (CDS), was sort of like fire insurance that you could buy for a house you do or do not own. Instead though, the J.P. Morgan product insured different kinds loans that included money borrowed by businesses and by countries.

Let’s fast forward to today. The CDS market has grown to more than $15 trillion. In the euro zone, the CDS has become a complement to bond buying. Does a bank want to purchase an Italian bond? To minimize its risk, it needs a corresponding CDS. How did we get from Alaska to Italy? That is another story.

Here is a more technical description of a CDS.

The Economic Lesson

Selling bonds called sovereign debt, Country A is the borrower and a bank could be the lender. However, like J.P. Morgan and the Exxon line of credit, the bank then enters Country A’s CDS market to reduce its risk. If Country A defaults, the CDS seller pays the bank that bought the insurance.

When investors buy Greek, Portuguese and Italian bonds can they buy the corresponding credit default swaps and “eliminate” their risk? It all depends on what “default” means.

An Economic Question: Explain how credit default swaps might be good and bad for a nation with a history of loan defaults.

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