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Credit default swaps

Introduction to credit default swaps. Created by Sal Khan.

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Video transcript

Let's say that I'm a pension fund, and I have money to lend to other people. And I want to lend it to other people, because that way I can get interest on it instead of it just kind of sitting and doing nothing. And if I lend it to someone other than the government, I'll get better interest. So let's say that there's-- so let me draw me, I'm the pension fund. Maybe I'll drawn me in magenta. So that's me, pension fund. And let's say that there's some corporation, let's say it's GM. They make cars. I think you've heard of them. Some corporation, GM. Let's just call it Corporation A. They need to borrow money, maybe to buy a factory or to do something else, we're not going to get involved in what they need the money for. And I'd like to lend them the money. But there's an issue here. I am a pension fund. I manage the retirement fund for the teachers of California, or for the auto workers of Michigan, or whatever. And part of my charter says that I can only invest in very, very, very safe instruments. So I'm not allowed to go gamble people's money, because this is people's retirement. So I can't do very fancy things with it. I can only invest in things that are rated AAA, or let's say AA. I'm just kind of making this up on the fly. So AAA would be like the highest rated securities, right? These are things that have a very low chance of default. But Corporation A is only rated, I don't know, let's say it's rated BB. And actually, this is a good time to think about well who is doing all these ratings. And you might think, oh, it surely is a government entity, because only the government would be objective enough give all of these corporations frankly objective ratings. But unfortunately, it's not. They're private entities, that are actually paid to rate things. And I think I touched on it in the video on collateralized debt obligations. But their incentives are a little bit strange. Let's say I have Moody's. Moody's is one of the ratings agencies, and they rate Corporation A as BB. So they've said, these guys, they're pretty good, but they're not the U.S. government or something. There's a chance that they can go under, for whatever reasons, or they're sensitive to the economy as a whole. And I say, man, I would love to lend these guys money. I would love to lend these guys the $1 billion that they need. And these guys are willing to pay me 8% interest. But I can't do it, me as a pension fund, I cannot lend them money. Because I'm only allowed to lend money to A or above types of bonds. Or I can only buy A or above type of instruments. So what do I do? This guy needs money. I have money to give him, but his corporate credit rating, that was given by Moody's, just isn't high enough for me to lend him the money. And this is where credit default swaps come in. In an ideal world, I would give Corporation A, I would give them $1 billion. And then maybe they would annually give me, let me make up a number, 10% per year. And then this might have a term for 10 years, and then after 10 years, they'll pay me the $1 billon back and then I'll be happy. But as I said multiple times, I can't do it, because they are BB rated. And my charter says I can only invest in A rated bonds. So I go to another entity. And let's call this entity AIG. And these entities are essentially insurance companies on debt. And I'm calling this one AIG because AIG actually did do this. But it could be anything. A lot of banks did this, a lot of insurance companies did this. There are some companies that just specialize in writing collateralized-- sorry, in writing credit default swaps. What does AIG do for me? Well first of all, it's important to note that Moody's has given AIG, I don't know, let's give it a AA rating. I don't know what their actual rating was. They said, you know what, they are almost risk-free. They're almost like the U.S. government. Moody's has looked at their books, or supposedly, or hopefully has looked at their books, and says, oh you know, if you loan them money, they're good for it. So they have a very, very high rating. Although, once again, you have to worry about the incentive. Because who paid Moody's to give them that rating? And whenever you're getting paid to give a rating, you have to wonder about what your incentives are, in terms of how you rate things. But anyway that's a discussion for another video. But what AIG says is, you know what pension fund? I know you want to lend Corporation A money, and Corporation A wants to borrow money from you, but you have this problem because they're BB rated. So what we're going to do is we're going to insure this bond. We're going to insure this loan that you're giving to Corporate B. What we want in return for that is an insurance premium. We want you to pay us a little bit of this interest every year. If you pay us a little bit of this interest every year, we will insure this payment. So you get 10% a year, and you give us 1% a year. So you give us 1% a year. And this is also 1%-- just to learn a little bit of financial jargon-- this is also someone would say 100 basis points. One basis point is 1/100th of 1%. So 1% of the same thing as 100 basis points. 2% is the same thing as 200 basis points. So you pay me 100 basis points of the 10% per year, and in exchange, I will give you insurance on A's debt. And in fact, it might have not even been structured this way. It might have been structured so that Corporation A right here, before even issuing the bonds, they include this insurance with the bond. So instead of giving 10%, they cut out 1% to insure it. And then these essentially become AA bonds. And why is that? Well, they're BB, but you're being insured by someone who is AA. So all of the sudden, these bonds, because they're being insured by this entity that is AA, which Moody's has determined is AA, these bonds are now good enough for my pension fund to hold. Because I said, you know what even if corporation A goes under, I have this AA guy insuring it. And so I'm fine. So this is the equivalent of holding AA bonds. And what's my effective interest rate? I'm getting 9% per year, right? I'm getting 10% per year from Corporation B, and then I have to pay 1% to AIG. And if Corporation B goes under tomorrow, AIG is going to give me my $1 billion back. And you might say, Sal, this sounds like a pretty good situation. And this is where it starts to get a little bit shady. Because AIG, they're not just insuring my debt or my loan that I gave to corporation A. And think about it, AIG didn't have to do anything. AIG didn't have to put up any collateral. AIG didn't say, you know what, out of all of our assets, here is $1 billion that we're going to set aside, just in case Corporation A doesn't pay. Right? You would think that if you wanted to be guaranteed that this money was going to come to you, this AIG corporation would have to set aside the money. But they didn't have to do that. They just have to say, hey, Moody's has said we're AA, we're good for debt. We're good for insurance. So you just pay us 1% a year and trust us, or trust Moody's, that we really are good for the money. They never had to set aside the money. You're just going on a leap of faith that, if and when Corporation A defaults, AIG is going to be good for the money. Now this is where it gets interesting. Let me erase Moody's from the screen-- actually, maybe I'll go down here. AIG didn't just insure my debt. Let's say that there is Corporation C's debt. Let's say that they're B-- I don't know, all these ratings have different terminology. They're B+ rated. Right? And let's say there's $10 billion of debt that they borrow from some other party. And in return, they give 11%. And this is Pension Fund B. And this pension fund had the same problem. They can only buy A-rated or above bonds. AIG also insures their debt that they gave to Corporation C. Maybe they'll pay them-- Corporation C is maybe a little bit riskier, so out of the 11% I have to pay maybe 150 basis points. Or 1 and 1/2%, that's the same thing as 1%. And in exchange, they insure C's debt. Now something very interesting can happen here. AIG all of the sudden has an excellent business model, right? Because they were able to get this AA rating from Moody's, they can just keep insuring other people's debt, and they don't have to put any money aside, right? They don't have to give their assets to anyone else. And they just get these income streams, right? From my pension fund they're getting 1% per year of $1 billion. From this pension fund, they're getting 1 and 1/2%, 150 basis points, per year. And they can do this, frankly, as much as they want. They could do this a thousand times. And as long as Moody's doesn't get suspicious. As long as Moody's doesn't start saying, hey, wait a second, AIG, you only have $100 billion in assets, but you have insured $1 trillion of other people's debt. Something shady going on, I'm going to lower your rating. As long as that doesn't happen, this AIG corporation can just keep insuring more and more debt. And frankly, as long as none of that debt goes bad, they just get this excellent income stream, and their CEO will get excellent bonuses. I think you start to see where you're having a single point of failure and a house of cards, and I'll continue that in the next video.