The First Credit Default Swap

If you own an asset that has the potential for loss or the potential to do damage to another’s property, you are wise, and often obligated to carry insurance on it. Life is filled with risk and risky events, there is no getting around that. People have different ways of managing this risk. Some like to roll the dice and take the chance that no loss will happen (risk retention). Some prefer to transfer the risk to an insurance company (risk transfer). Still others decide not to take risk at all (risk avoidance).

A “credit default swap” is essentially like a warranty or insurance policy against loss from an investment, typically a bond. Say, for example, Company A decides to invest in some bonds of XYZ Corporation and would like to transfer the risk of loss from these bonds. Company A is seeking a partner that will write a contract with them to take on the risk of default from the XYZ bonds that Company A purchased. They want insurance in the event of financial problems with XYZ. Here is where Company B comes in. Company B decides that they are willing to allow Company A to transfer the risk of the bonds to them. If the XYZ bonds default, Company B will compensate Company A. Company A will pay Company B an upfront “premium” and then an ongoing payment, typically on an annual basis. The terms of these contracts can be anything.

The Exxon Valdez oil spill occurred in Prince William Sound, Alaska on March 24, 1989. The Exxon Valdez, an oil tanker owned by Exxon Shipping Company, was on its way to Long Beach, CA when it struck Prince William Sound’s Bligh Reef. The crash resulted in 10.8 million gallons of crude oil being spilled into the water over the next few days. The region is a habitat for salmon, sea otters, seals and seabirds. It is considered one of the most devastating human-caused environmental disasters in history. The oil eventually covered 1,300 miles of coastline and 11,000 square miles of ocean.

A jury eventually ruled that Exxon Mobil (XOM) was responsible for paying $5 billion in punitive damages. This was the equivalent of one years of Exxon’s profits at the time. The damages were later reduced to $2.5 billion and then again reduced to $507.5 million in 2008.

In 1994, Exxon was looking for a way to protect itself if the $5 billion award was ever affirmed. Subscribing to the “OPM” principle, the company took out a $4.8 billion line of credit with JP Morgan (JPM). This created a bit of problem for JP Morgan because , under the banking rules at that time, banks were required to withhold eight percent of their capital against outstanding loans. This meant that they would be tying up $384 million. Needless to say, they didn’t want to do that.

A member of JP Morgan’s swaps team hit upon the idea of the credit default swap as a way for the bank to sell the credit risk associated with the Exxon loan to the European Bank of Reconstruction and Development (EBRD). The EBRD stood to gain a substantial return for taking on the risk of Exxon defaulting, while JP Morgan was able to keep more cash available for other things and greatly reduce its own risk by laying it off to someone else. They chose “risk transfer”. This was the first credit default swap. If Exxon defaulted on the loan, JP Morgan sold the risk to someone else.

Years later, the credit default swap, like every other financial innovation, was bastardized and abused until it brought the financial system to the brink of collapse. It was used to transfer the risk of sub prime loans. Then that transferred risk was sold again and on and on and on.

DISCLOSURE: This article is written for informational purposes only and should not be construed as financial advice. It should not be relied upon, in any way, to assist in making financial decisions. I do not personally own any of the stocks mentioned here and do not plan to initiate any positions in the stocks discussed here. Please perform your own due diligence or consult a qualified financial or investment advisor.

Sources:

  1. Wikipedia, Exxon Valdez
  2. Justin Rohrlich, How The Exxon Valdez Spill Created the Credit Default Swap, Minyanville, May 27, 2010.