From NPR News, this is All Things Considered. I'm Michele Norris.


And I'm Robert Siegel. Today we'll explore an obscure financial product that's been wreaking havoc across the globe: credit default swaps. If bad mortgages got the financial system sick, then credit default swaps helped spread the illness worldwide. Alex Blumberg of Chicago Public Radio's "This American Life" reports on where CDSs came from and why investors found them irresistible.

ALEX BLUMBERG: Like many parts of the financial system these days, credit default swaps are so complicated, simple bankers couldn't have created them. They're invented by people like this guy, Gregg Berman.

Dr. GREGG BERMAN (Co-head, Risk Management Unit, RiskMetrics Group): Actually, my formal training is in physics. So I studied experimental physics and nuclear physics before joining finance in 1993.

BLUMBERG: Now just to be clear, Gregg didn't invent these things. But he works for a company, RiskMetrics Group, which you won't be surprised to learn helps people manage risk. And so he thinks about them a lot, and he's good at explaining what they are. Imagine, he says, you buy a bond from Ford for $100.

Dr. BERMAN: You're holding the bond, and you are worried about Ford's credit. So you enter into an agreement with another party where you say to the other party, I will pay you some money. I'll pay you two percent a year, three percent a year, four percent a year, and what you need to do is give me protection. If Ford should go bankrupt, then I'm going to give you back this perhaps worthless bond, and you're going to give me my $100 back. In the big context of things, it looks like insurance.

BLUMBERG: So, insurance? That's what we're talking about here? People with bonds which are already considered pretty safe trying to make them safer? Well, it didn't stay that way.

Mr. SATYAJIT DAS (Risk Consultant): I think Mae West once said it very, very well when she said, "I used to be Snow White, but I drifted."

BLUMBERG: This is Satyajit Das. He goes by Das. He's a risk consultant who was around when credit default swaps first appeared. NPR economics correspondent Adam Davidson and I talked to him and heard stories from his 30 years working with hedge funds and bankers all over the world as a sort of financial hired gun. He saw firsthand how what started as insurance morphed into something else entirely. In the 1990s, he says, he was a fan of credit default swaps.

Mr. DAS: But by about 2003, 2004, I was starting to get very nervous because what I could see was the market had gone from a very legitimate purpose to something which was much more racy and interesting, but also much more dangerous.

BLUMBERG: So this clearly had stopped being insurance somewhere along the way?

Mr. DAS: Oh, absolutely it stopped being insurance.

BLUMBERG: And it became gambling?

Mr. DAS: Well, you know, the line between investing and speculation or gambling in financial markets is always a pretty gray one, but yes.

BLUMBERG: So, how did we get from one of the safest activities on the planet, insurance, to one of the riskiest, gambling? Well, there's one key difference between an insurance policy and a credit default swap. Again, here's Gregg Berman.

Dr. BERMAN: The way that I first described the credit default swap is that you own the bond and you'd like to transfer that risk to someone else. But what if I want to buy protection, but I don't own the bond?

BLUMBERG: So why would I buy protection on a bond I don't own? Isn't that like buying fire insurance on a house I don't own?

Dr. BERMAN: It is exactly like buying insurance for a house that you don't own. So it's like you took out fire insurance on your home, and now I also took out fire insurance on your home, and a thousand other people took out fire insurance on your home.

BLUMBERG: When that happens, what you're doing is you're betting on the house. So, did you get that? A CDS allows people to get paid off by insuring something they don't own. Not a house in this case, but a bond. Here's how it works. A credit default swap is what they call an over-the-counter instrument, meaning it's not something that's traded publicly on an exchange, like a stock. It's a private deal between two people. Those two people can be anyone. Well, anyone with more than $5 million. So that means effectively someone at an investment bank or a hedge fund or at a big commercial bank like Citibank or Credit Suisse. They all have credit default swap desks.

Now, every day the people at this desk are getting thousands of emails and calls from people wanting to enter into credit default swap contracts with them. Sometimes the people calling want it for insurance. They have a bond from, say, the ABC Company, but they're a little worried about the ABC Company's financial health. They call the people at the credit default swap desk and they say, will you sell me credit default swap protection? Will you guarantee that if the ABC Company goes down, you'll guarantee the full value of the bond? But sometimes, often, Das says, they don't have the bond. They just have a hunch about the ABC Company.

Mr. DAS: So they want to essentially bet that ABC Company will default. So he and I agree that if ABC Company defaults, I will pay him a certain amount. And in return he pays me some fees.

BLUMBERG: Das says that during his time in the industry, the amount of credit default swaps that were speculative grew to dwarf the amount that were actually used for insurance. The numbers are staggering. There are $5 trillion worth of bonds issued in the world, but the total amount that people have bet on those bonds is over 50 trillion. That means that for every one person using a credit default swap to ensure a bond, there are more than 10 people using a credit default swap to bet on it. And there's one more thing.

Professor ANDREW ANG (Finance, Columbia University Business School): All of this is unregulated, partly because they wanted it to be unregulated.

BLUMBERG: This is Andrew Ang, a professor at Columbia University Business School who studies the credit default swap market. One of the reasons that they wanted it to be unregulated has to do with a word that you hear a lot when you talk to finance people. That word is leverage. Here, I'll show you. When you operate on leverage...

Mr. DAS: The market had become extremely driven by its lust for leverage.

Professor ANG: Part of the problem with these swap contracts, they actually have extraordinary high leverage.

BLUMBERG: See what I mean? Well, here's what they mean by leverage. Say I have a hedge fund with $100 million, and I want to make a killing in the credit default swap market. I start calling and emailing to all those credit default swap desks and hedge funds out there saying, I'm selling protection, who wants to buy? Someone calls me and says, I have a billion-dollar bond from Lehman Brothers. I want to ensure it. I say, great. I will ensure your bond if you agree to pay me two percent of its value every year. He says all right, and we're in business.

Now, let's review these numbers. Two percent of a billion dollars? That's 20 million which I get every year. My hedge fund: $100 million. So I've signed one piece of paper, and in five years I've doubled my money. I'm psyched, my investors are psyched. That is the upside of leverage. I'm making profits on $1 billion, even though I only have 100 million. The downside of leverage is that now I'm on the hook for up to a billion dollars if the bond defaults. And I don't have a billion. In 2005, this particular bet on a Lehman Brothers bond seemed like a sure thing. The idea that Lehman Brothers, one of the oldest and largest investment banks in the world, could possibly default seemed crazy. In 2008 it became scarily, unbelievably real.

(Soundbite of music)

SIEGEL: Tomorrow, reporter Alex Blumberg explains the role credit default swaps played in destabilizing the global financial system. This is NPR, National Public Radio.

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