Origins
The Credit Default Swap (CDS) was invented by Blythe Masters and her team at J.P. Morgan in 1994 as a mechanism to transfer credit risk off bank balance sheets. The technology solved a specific problem: banks held large loan portfolios that tied up regulatory capital, and they wanted a way to retain customer relationships while offloading the risk of default.
The CDS functions like an insurance policy: the “protection buyer” pays a periodic premium to the “protection seller,” who agrees to compensate the buyer if the referenced borrower defaults. Unlike actual insurance, however, CDS were not regulated by insurance commissioners and required no reserves against potential claims.
Structure & Function
The core mechanism of the CDS is the separation of credit risk from the underlying asset. A bank could make a loan to a corporation, then buy CDS protection from a third party, effectively eliminating its exposure to that borrower’s default. This allowed banks to maintain lending relationships while managing their risk portfolios more dynamically.
The technology was extended to mortgage-backed securities with almost no capital requirements, allowing firms like AIG Financial Products to collect premiums that executives viewed as “almost free money” because models suggested the probability of an actual economic loss was “close to zero.” CDS contracts included “collateral triggers”—if AIG’s credit rating dropped or the market value of the underlying tranches fell, AIG was contractually forced to post billions of dollars in cash collateral.
Historical Significance
The CDS is historically significant for its role in enabling the securitization machine to operate at an infinite scale. Through Synthetic CDOs, which consisted of credit default swaps rather than physical mortgages, Wall Street could “clone” risky debt and create a theoretically limitless supply of securities to meet investor demand.
The technology eventually became a “neutron bomb” within the financial system during the 2008 crisis. AIG-FP had written $500 billion in credit default swaps on mortgage-related securities, and when these positions collapsed, the U.S. government was forced to provide a $180 billion bailout to prevent global contagion. The crisis led to calls for CDS regulation through central clearinghouses, though the market remains largely opaque.
Key Developments
- 1994: Blythe Masters and the J.P. Morgan team invent the first modern credit default swap.
- 1997: J.P. Morgan launches BISTRO, the first synthetic credit derivative offering.
- 1998: Brooksley Born attempts to regulate the derivatives market but is thwarted by the Treasury and the Fed.
- 2000: The Commodity Futures Modernization Act officially exempts swaps from regulation.
- c. 2004: AIG-FP begins selling protection on multisector CDOs stuffed with subprime mortgages.
- 2005: Standardized CDS contracts for mortgage-backed securities are developed by firms like Goldman Sachs and Deutsche Bank.
- 2006: The CDS market reaches a notional value of tens of trillions of dollars.
- 2007 (July): Goldman Sachs issues the first massive $1.8 billion collateral call to AIG-FP.
- 2008: AIG-FP’s unhedged $60 billion subprime book collapses, necessitating a massive federal bailout.
- 2009: Central clearinghouses for standardized CDS begin operating.
- 2010: Dodd-Frank Act mandates central clearing for most standardized swaps.
- 2012: CDS market remains significant but more regulated than pre-crisis.