I love catching up with my mom. She’s very interested in the topics I write about on the blog, but she also does a really good job of letting me know where the gaps are in what I talk about and what you may be understanding. I have the same problem when my bond-trader friend talks about his work, it’s way over my head. So she heard somewhere on NPR (tried to find a link but couldn’t find anything) where they tried to explain exactly what a CDS was in simple terms. A credit default swap (CDS) is essentially taking insurance out on your neighbor’s house. If their house burns down, you make a bunch of money. So naturally, you want the house to burn down. Right? It was so disappointing to learn this is how NPR thought it best to explain a CDS. First I’ll explain why this was a bad analogy, secondly, I’ll give you a better one.

Are you married? Does your spouse have life insurance? Do you want your spouse to die so you can get the money? If you answered “YES, YES, and YES!!!” please turn yourself into the authorities. But I suspect most of you have a “yes, yes, no” response. And the unmarried ones may still have life insurance but probably aren’t worried about their benefactor killing them or hoping for a timely death. So if we don’t have insurance so we can make a boatload upon killing someone, then why do we have it? We have it because if we die, someone needs to replace our income. I have value to my wife, just as my wife has value to me. If either of us dies, insurance would help fill the economic void left behind. You take out insurance on your neighbor’s house for a good reason. If it burns down, the value of your property declines as well.

So in my conversation with my mother I came up with a great analogy that better fits the purpose of a CDS. Imagine your neighbor is running a meth lab in the garage. The process of making crystal meth is chemically intensive and can result in explosions. If the garage explodes, the house burns down, and the fire/explosion may damage your house as well. Either way, this meth lab poses a threat to the value of your home. So what do you do then?

You take out a small insurance policy on your neighbor’s house. The insurer thinks this is crazy but is glad to sell you a policy for a pittance. Even your neighbor thinks you’re crazy; only you know what the danger is with the meth lab. If the lab explodes, through some manner or another, the value of your home will decline. Sure enough, the lab explodes and the house burns down. Now the neighborhood is scarred with a giant burnt property and everyone knows drugs were being sold in the neighborhood. Naturally, the value of your home declines.

So how does this related to a CDS? Someone like John Paulson knew two things about mortgages, the first was they there were overvalued. The second was that when everyone else started to realize that, it was going to cause problems that went far beyond real estate prices. As this happens, even Paulson would lose money unless he did something to protect himself. So he started a fund that was specifically designed to purchase the type of insurance I described above (note, he also used other resources with similar payoffs). Investors in the fund were just people that wanted the same kind of insurance. If the meth lab burned down and you made a bunch of money, main street and Congress would now be mad at you.

A credit default swap is simply insurance against the risk of someone defaulting on their loan. It’s most commonly purchased by people that would directly lose money if a specific loan defaults, but an argument can be made that anyone should have a right to make that purchase. Paulson didn’t want these mortgages to fail, he just knew that many of them would. I don’t want this to turn into a conversation about whether or not investors should be allowed to buy CDSs, but I wanted to at least make sure my readers understand how a CDS works. If you have questions or more to add, please toss it in the comments. But try to keep them away from whether or not investors should be allowed to buy CDSs, we’ll do that another day.

Photo: DVS

By The Weakonomist

The Weakonomist is the founder of Weakonomics. Clicking the picture of the puppy will tell you more about him. If you like what you're reading consider subscribing to the blog, following him on Twitter, and checking out the related posts below. Please consider a donation if you really enjoy Weakonomics. Also keep in mind that nothing I say can be construed as financial advice.

categories: banking, investing, loans