Why Is Everyone Talking About Credit Suisse? Credit Default Swaps Explained
Investors are concerned about Credit Suisse's financial health, fears of another Lehman Brothers moment
Over the weekend, Credit Suisse, the second largest bank in Switzerland, has been in the news primarily for its credit default swaps spike, which led many analysts to compare it with Lehman Brothers in 2008.
What is credit default swaps:
Credit default swap (CDS) is a form of insurance that protects a party against payment defaults.
Banks like Credit Suisse often sell bonds to investors to raise capital to invest in their businesses. Bonds are debt securities. Overtime, banks need to pay back their bondholders principal and interests. However, if a bank goes bankrupt, it may not be able to pay back the full amount it owes to its bondholders. To help manage that risk, bondholders can buy CDS to transfer the risk to a CDS seller who acts as a insurance provider. In the event of a default, the CDS seller has to pay the full amount to the CDS buyer.
CDS is a type of derivative contract. Just like options, they are derivative contracts entered into between two parties (a buyer and a seller). Buyers buy CDS to protect themselves against the risk of non-payment. Sellers sell CDS to make money on the premiums, just as an automobile insurance company insures cars.
The role in the 2008 financial crisis:
CDS is invented by JP Morgan Bank in 1994. By the end of 2007, according to Corporate Finance Institute, the value of CDS stood at $45 trillion compared to $22 trillion invested in the stock market, $7.1 trillion in mortgages and $4.4 trillion in U.S. Treasuries.
Many financial institutions were involved in CDS trades, one of the biggest was Lehman Brothers, which owed $600 billion in debt, out of which $400 billion was covered by CDS according to Forbes.
Lehman Brothers bought the CDS contracts from financial institutions such as American Insurance Group, Pacific Investment Management Company, and Citadel. Banks historically do not usually go out of business, so these CDS sellers did not expect Lehman Brothers would default. When Lehman Brothers declared bankruptcy, American Insurance Group lacked sufficient funds to cover swap contracts, and the Federal Reserve of the United States needed to step in to bail it out.
After the event, CDS became regulated.
Why is it important:
Credit Suisse’s five-year CDS is currently priced at 250 basis points, very close to its 2008 level according to Bloomberg (screenshot below).
If the CDS on Credit Suisse's debt gets too expensive, it means that investors don’t trust the bank and the bank will be likely unable to raise capital when it is needed to meet its financial obligations. Plus Credit Suisse has been losing money since the beginning of the year according to its quarterly earnings report. Its stock price dropped 54.6% year-to-date compared to 12.6% of S&P Banks Select Industry Index.
If a large bank like Credit Suisse goes out of business, it will have a severe impact on the global economy.
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