Warren Buffett famously called financial derivatives “weapons of mass destruction,” and the wisdom of these words reverberated throughout markets after the subprime mortgage crisis and the Great Recession. If you watched (or read) The Big Short, you know that derivatives caused bank failures due to massive losses building up all at once—and that this, beyond the fundamental decline in home values, was what really drove the world into a financial catastrophe that, to this day, remains the worst financial crash in a century (while the COVID-19 market crash and 2022 inflation spike are both bad, they still pale in comparison in terms of lost GDP, lost productivity, lost incomes, wealth—just about according to any indicator).
This all happened because of derivatives, so now that inflation is spiking, the market is tanking, and investors are getting worried everywhere, should we worry about toxic derivatives recreating the horror of 2008—or even creating an even more horrific dystopia.
To answer that question, let’s look at credit default swaps (CDS), a financial derivative that was at the backbone of 2008’s crisis (that crisis was driven by MBS, or mortgage-backed securities, but MBSs are really just a subtype of CDSs). These are pretty easy to understand, if you think of them as insurance (which, in fact, is how they’re almost always used).
Let’s say I’m a creditor and I’ve bought a company’s bonds—they pay me interest in exchange for the access to capital I give them. However, I want some assurance that the company will pay me back, so I buy a CDS from a third party—most likely a bank or similar institution. The bank promises to pay me if the company defaults, and in exchange I pay the bank some cash for that insurance. If the company doesn’t default, I get my money back and the interest from the bond, the bank gets to keep the cash I paid them for the CDS, and the company had access to capital that it used for whatever reason it needed capital. Everyone wins.
In times of volatility, however, the cost of a CDS goes up. The risk that the company will default has gone up, so the bank needs more cash to issue the CDS in exchange for the greater risk that they will default. In essence, the cost of my insurance has gone up.
Note that CDS instruments aren’t solely used as insurance, and this is where the problem in 2008 came about. Many groups were buying CDSs simply to own them to speculate on a crash, and banks were greedily issuing more of this kind of insurance than they could afford if a market crashed, which is why 2008 was such a huge disaster globally—it literally broke the banks and forced a lot of restructuring of the financial world.
That restructuring has made the system much safer, which is why the risk of a CDS-driven cascade of defaults is unlikely; banks just aren’t issuing too much insurance at the absurd levels they indulged in over a decade ago.
There’s another dimension to this to consider. Not everyone who buys CDSs is hedging a portfolio of debt, and indeed some aggressive funds have been pivoting away from owning debt outright to solely selling CDSs, because the premium there has gone up and up.
This is a bit more complicated, so think of this example: Fund A has lent Company 1 some amount for x% in interest. Company 2 has borrowed money from Fund B for x+0.3x% in interest. The value of Company 1 and Company 2 bonds has fallen in the higher interest rate and more risk-averse market. Seeing an opportunity, Fund A sells a CDS regarding Company 2 to Fund B for y dollars. Fund B pays, hedging for the uncertain market, while Fund A keeps that premium and then, in a few months when the value of that CDS has gone up because volatility has risen, Fund A sells the CDS to Fund C.
Assuming that the market begins to recover, which fund will outperform: A, B, or C?
The answer is unquestionably A. While B has had insurance, it hasn’t needed to exercise that insurance because the market recovered and, presumably, Company 1’s cash flow and bond recovered alongside it. C bought the CDS too late, so when the market recovered and premiums fell the value of its CDS most likely fell too. It’s only A, who provided insurance, never had to pay that insurance, and then sold off the insurance policy for a profit, who really did extremely well. It did so twice: firstly by taking on more risk than the market was comfortable with, then by offloading that risk just before signs of the market recovering.
While it is a truism among retail investors that one cannot time the market and outperform the index (and this is true for the U.S. large cap stock market, as study after study reveals), the complex analysis of risk involved in the CDS game of musical chairs described here has resulted in alpha generation for many credit funds—many of which have demonstrated said outperformance for years.
If the inverse happens and the market gets worse, Fund A may indeed be the worst performer—or it might not. It really depends on whether Company 1 defaults as the market crashes—remember that not everyone defaulted on their mortgages in 2008, and similarly a widespread economic collapse would not necessarily result in every company collapsing at the same time.
This is an asymmetrical risk profile, and the best bond funds can utilize that asymmetry to play both the bond and bond derivative markets to astounding success. But getting the analysis right is crucial—as well as relying on a fundamentally sound market of CDS issuers, buyers, and sellers. And although inflation is high, borrowing rates are soaring, and the market is developing a massive allergy to risk, there’s no evidence that the market today looks anything like 14 years ago. At least not yet.
