By: Jeff Davis
Online Business Program Chair
You may be following the news about JPMorgan’s $2 billion trading loss that is currently rattling financial markets. Would you believe that the investment that caused this loss, called a credit default swap, is the exact type of investment that caused the financial crisis?
A credit default swap is essentially an insurance policy on a bond or group of bonds. If you own a bond, one of the risks is that the issuer of the bond will stop making payments, which is called a default. You can protect yourself against this risk by purchasing a credit default swap (CDS). Just as you do with car insurance or homeowner’s insurance, when you buy a CDS, you pay a small premium. In return, you are compensated when you experience a loss. A credit default swap is an important and perfectly legitimate method of protecting yourself from loss on an asset that you own.
On the other hand, a credit default swap can also be used as a pure bet. For example, you can purchase a CDS on an asset that you don’t own. As an analogy, this would be like you purchasing car insurance on a driver you don’t know in a different city. You make premium payments and hope that this unknown driver gets into a wreck so that you are paid off on the policy.
As another example, you could sell a CDS, which means that you collect insurance premiums from people, but have to pay them off when they experience a loss. This is what insurance companies do. It works when you have good information about the risks (for example, the average number of car accidents), and you keep a pool of funds large enough to make payoffs when people get into accidents. However, in the financial crisis, investment banks were selling enormous numbers of insurance policies on subprime mortgage bonds, without nearly enough funds to make payoffs when these bonds went bad. Imagine telling someone about to jump off a six-story building, “Give me $1 for an insurance policy, and I’ll pay you $1,000 if you break your leg.” Except do this for a billion people all about to jump off a building.
The current situation with JPMorgan shows that we have not done enough to prevent future crises. The bank has repeated the same mistakes that led to the bailouts of 2008-2009, as well as the bailout of LTCM in 1998 under astonishingly similar circumstances, the savings and loan crisis of the 1980’s, and a string of corporate bailouts going back to at least 1971. What do you think we should do to stop this cycle of companies becoming “too big to fail,” having virtually no restrictions on their actions, and then receiving a taxpayer-funded bailout?
For more information on the JPMorgan situation, you can read the article linked below or perform a news search for JPMorgan. http://www.bloomberg.com/news/2012-05-14/jpmorgan-losses-spark-frenzy-in-swaps-indexes-credit-markets.html
For more information on credit default swaps and other derivative investments, check out the Globe Education Network course FN450 Derivatives.
For more information on the financial crisis, I recommend Bailout Nation by Barry Ritholtz. Bailout Nation is available as an e-book at our Online Library!