I’m paraphrasing James Hamilton here.
A credit default swap is a contract that pays out if a specified event occurs on the underlying security. Normally, and in this case, the security is some debt and the event is a default on that debt.
There was a pile of $29 million in debt. Specifically, they were (based on) subprime loans in California and a bunch of them were already delinquent.
A brokerage firm from Texas started offering (i.e. selling) credit default swaps on the $29 million. Since so many of the underlying loans were delinquent, it seemed a sure thing that a default would occur and the big boys in New York were happy to buy the CDS contracts. In fact, they were so sure that the debt would default that they were willing to pay up to 80 or 90 cents for a $1 payout in the event of a default.
Two important things then played a role: First, credit default swaps are traded “over the counter”, so if you buy one from me you don’t know how many other people have also bought from me or how many they each bought. Second, there are (currently) no regulations on credit default swaps and in particular, there is no limit to the scale of the CDS market against a particular asset.
In this case, the big banks paid about $100 million for CDS contracts that would pay out $130 million if the debt defaulted.
The brokerage firm took the $100 million, paid off the debt entirely (so it didn’t default) and walked away with $70 million.
If derivatives, and specifically CDS were insurance, would this deal be declared a moral hazard and the insurance invalidated?
Take for example a situation where a ship has been captured by pirates and the ship owner refuses to negotiate (enforced by law or reinforced by past practice) so the ship is certain to be lost. An insurer offering insurance contracts on the cargo and ship without requiring an actual interest might get a lot of takers, with the insurer then using the proceeds to pay the ransom even contrary to the owners wishes. But let’s go a step further, the insurer contacts the pirates after the ship has been captured and negotiates the ransom, then sells the insurance contracts to those without an actual interest in the cargo.
Going a step further, the pirates are the ones offering the insurance; if they can convince multiple speculators to buy insurance for the cargo without having an interest, then they let the ship go through, but if they get only an single insurance contract, then they capture the ship and take the cargo, sell it and pay off the insurance claim, breaking even or making a small profit, but thereby setting the expectation of huge profits on future ships entering area where the pirates operate.
I think this analogy might serve to describe such things as naked short selling hedged with swap, and the buying of large interests of corporations with the threat of a hostile takeover and liquidation.