A credit default swap (CDS) is a financial derivative, or contract, that protects a commercial real estate investor from bond risks. It enables the investor to offset or “swap” their credit risk with that of another investor. For instance, if a CRE investment company is worried that the person who is the borrower will default on a loan, they could use a CDS to swap or mitigate that risk.
To swap the risk of default, an investor will buy a CDS from another lender who agrees to reimburse the investor in the event that the borrowing company defaults. Many CDS contracts are sustained through continuous premium payments that are similar to the traditional premiums due on an insurance policy. Much like an insurance policy, a CDS will protect investors from unlikely yet devastating events.
However, an insurance policy provides an indemnity against any losses actually suffered by the policyholder on their assets that hold insurable interest. By contrast, a CDS will provide all holders with an equal payout that is calculated utilizing an agreed, market-wide methodology.
A CDS can involve mortgage-backed securities, corporate bonds, junk bonds, collateralized debt obligations, municipal bonds and emerging market bonds.
How Does a Credit Default Swap Work?
Let’s assume a company issues a bond. Several other businesses purchase the bond, therefore lending the company funds. These businesses want to ensure they don’t get burned if the borrowing company defaults on payments, so they buy a CDS from a third party.
The third party then agrees to pay any outstanding amounts on the bond if the lender defaults. Often, the third party is a bank, insurance company, hedge fund or reporting dealer. The swap seller will collect the premiums for providing the swap, typically on a quarterly basis.
Pros and Cons of a Credit Default Swap
The biggest benefit of a CDS is that it protects lenders against credit risks. This financial shield allows investors to fund riskier ventures they might otherwise avoid.
Swaps were largely unregulated until about 2010. There wasn’t any oversight from a government agency to ensure the seller of the swap had the funds to pay the holder if the bond or investment defaulted. Thus, these swaps gave a false sense of security to investors. They felt confident buying risker and riskier debt, believing a CDS would safeguard them from any losses.
Nowadays, stricter limitations on credit default swaps are being used by insurance companies and banks to mitigate risks. Additionally, CDSs are monitored and regulated by the Securities and Exchange Commission (SEC) and are subject to federal prohibitions on insider trade, fraud, and market manipulation. The Office of the Comptroller of the Currency can inspect how banks’ usage of credit default swaps impacts bank security.