WASHINGTON — The use of credit-default swaps, or private, insurance-like contracts, exploded in recent years into a murky, $60 trillion worldwide market with little government scrutiny.
Under such contracts, the buyers agree to pay premiums, as often as monthly, in return for the issuers' enforceable guarantee to pay agreed-upon sums if certain events occur. Most swaps revolve around whether a company or borrower will default on a credit line or loan or go into bankruptcy, but a swap can be a bet on anything.
When it came to subprime mortgage securities, the swaps market morphed into a way for major banks to pass huge risks around like loaves of bread, especially in offshore deals that skirted the disclosure requirements of U.S. securities laws.
Swaps added a new twist to offshore deals called collateralized debt obligations, or CDOs, in which banks attracted foreign investors by offering high-yield structured securities backed by bundles of mostly investment-grade U.S. debt that often included subprime loans to borrowers with weak credit.
Beginning around 2005, some of these deals took on a different look. Some consisted solely of a series of credit-default swaps that amounted to bets that a pool of securities backed by risky mortgages or other loans would default. Investors would typically collect about a 1 percent annual premium for issuing the protection and also would get a return on securities, sometimes Treasury bills, in which their money was parked during the term of swap contract.
More commonly, Goldman Sachs and other investment banks designed hybrid deals. In most of these, 80 percent or more of investors' money went into high-yield securities, just as before. The balance, however, was used to provide swap protection. As in the deals built entirely around a swap, the hybrid deal wouldn't buy the securities being insured, but would only track their performance, on which the bet was riding.
Investors got what they thought would be safe returns on mostly Triple-A rated investments, a premium from the swap buyer and a nice yield on the money they put up to cover the swap — a handsome return, many may have thought. A default, however, could require investors to pay the other party the face value of the swap.
Later deals got even tougher on investors, requiring them not only to cover any deterioration in the securities' market value, but also to pay up if the securities were downgraded by Wall Street rating agencies.
When the U.S. housing bubble burst, so did the underlying securities on many Cayman Islands deals. Losses on the CDOs and the swaps are estimated to be in the hundreds of billions of dollars, but few of the losers have surfaced publicly.
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