Credit Default Swaps: Exxon Valdez, Naked Bets and a $62 Trillion Market

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A credit default swap is a contract in which a buyer pays regular premiums, called the spread, to a seller who promises a payout if a reference entity defaults on its debt. The modern version took shape at J.P. Morgan in 1994 under Blythe Masters. Exxon, facing a possible $5 billion in punitive damages over the Exxon Valdez spill, asked for a $4.8 billion credit line, and Basel I rules would have forced the bank to hold 8 percent of it in reserve. J.P. Morgan paid the European Bank for Reconstruction and Development to take on the default risk, freeing its capital. In 1997 the bank built BISTRO, chopping credit risk into small pieces, an early form of the synthetic CDO.

The Commodity Futures Modernization Act of 2000 declared swaps neither futures nor securities, leaving them outside SEC and CFTC oversight. Naked swaps, bought by people who did not own the underlying debt, grew to about 80 percent of the market, and notional value rose from $300 billion in 1998 to $62.2 trillion by the end of 2007. Lehman Brothers had about $155 billion in debt but roughly $400 billion in swaps written against it, though netting meant only about $7.2 billion changed hands. AIG had sold protection without reserves and needed an $85 billion federal rescue. Central clearinghouses arrived in 2009, yet in 2012 the trader known as the London Whale lost J.P. Morgan $2 billion on CDS index bets.

• Settlement can be physical, handing over defaulted bonds for par value, or cash, paying the gap between face value and market price.
• Unlike insurers, swap sellers were not required to keep cash reserves backed by actuarial math.
• AIG's models treated defaults like independent car crashes, but in the housing bust they all failed together.
• In 2011 the IRS proposed treating swaps as notional principal contracts rather than insurance.
• George Soros called the instruments toxic, and Warren Buffett called derivatives financial weapons of mass destruction.