Credit Default Swaps.
Not the things you put in your ears.
When you buy an asset you take on risk of losing it. If you buy a watch you can literally lose it down a culvert or a stripper might steal it. Neither of these things have happened to me of course.
You can metaphorically lose it also by leaving it in your jeans and you accidentally run it through the washer spin cycle. This has happened to me though.
In the first situation you are left with just a memory of your watch in the second you still have a watch. It’s just a broken watch.
If you are prone to such things you can buy insurance for your watch. So that in the event your child gives it a swirly in the toilet you can get back some of the value of the asset. If the watch has gone up you can insure it for more than you paid.
If you buy a stock you similarly can buy insurance via stock options this can protect you from the value of the stock going down.
If you buy a bond the risk is not that the value of the bond will go down but that the company that sold the bond will no longer be able pay the installment. The point of buying a bond is to secure a guarantee of income. Missing a payment means the bond is in default. This could mean the company is in deep shit. Or just is having a momentary cash crunch.
You can buy insurance against this by purchasing a credit default swap.
They say history doesn’t repeat but it often rhymes. Market history literally repeats itself all the time because there are very few tricks that make money. And people just forget what happened the last time.
What is happening now (as of last month really) is bond holders are starting to take out insurance on bonds recently issued. Notably, to Oracle and META. And they are priced at a premium implying that those holding the bonds consider them slightly riskier than the standard index of bonds. Banks are always hedged. But, other buyers may not be so changes in the swaps market means something.
You should start paying attention to this because they might make a movie should one of these companies default. This is not very likely with META. But, MSTR, some of the PVE involved with Nvidia might eventually have issues making bond payments.
The CDX is trading at 40 bps say and META is at 56. (I haven’t looked but that’s probably close) This means the bank can buy insurance for 40 cents/year payable quarterly to insure $1 million. As the riskiness of the bond changes the price of the insurance changes. So you can lock in this for a period of time usually five years. You can also see this risk elevation in the price the bond is trading on the secondary market if there is a secondary market.
If a company defaults what happens is the bond goes to the International Swaps and Derivatives Association (ISDA) for auction (almost all the time.) (An isduh (ISDA) is mentioned in The Big Short in regards to an ISDA Master Service Agreement (MSA) so now you know what they were talking about. An MSA is just an agreement on how two parties are going to trade with each other when dealing in over-the-counter securities.)
Whatever the price achieved at the auction determines what is paid out to the holder of the insurance. So if a bond sells for 90% the bond holder gets 10% back from the insurer. If the bond sells for 10% the bank gets 90%.
If you pay for a CDS for 40 cents ($4000/year) on $1 million and the company collapses and the bond falls to zero you make $1 million. If the company doesn’t collapse in five years you lose $20k. This way a bank can lower its risk cheaply.
Potentially, you can make a lot of money buying a CDS as well if you don’t own the bond but just want to profit off its collapse in value.
Now, go re-watch The Big Short again and instead of mortgages think about chips and data centers.
— AJ