Could You Help Me Understand Credit Default Swap in Terms of Purchasing a Car?

BY busadmin  December 8, 2008 at 12:18 PM EST

Question/Comment: The lease is up on my Lexus and I inquired about buying it. Lexus financial said that I’d have to pay the residual value from the lease. That amount is $10,000 over market value. It was later explained to me that Lexus (aka Toyota Financial) got insurance on the difference between the residual value and market price. So Lexus might as well collect on the insurance instead of selling to me at market value. Is this essentially a credit default swap?

Paul Solman: What a great question. The simple answer is “sort of.”

First of all, a credit default swap IS insurance: neither more nor less. We explained as much on the NewsHour awhile ago in such a low-budget way that Jon Stewart mocked us on the Daily Show.

My explainer is below, if you would like to re-watch it.

For those of you who do not want to re-watch it, the point of the explainer was that you can buy insurance against loss when you lend someone money. Let me take another crack at it.

Say that someone you know, say Sister Samara (I’m tired of “Uncle Sam” and even “Aunt Samantha”), is the U.S. Treasury. You lend her ALL your money. In return, she gives you legal promises, known as Treasuries, that pay a regular rate of interest and she’ll reimburse your principle at a specified date.

But something unforeseen happens and Sister Samara (i.e., the U.S.
Treasury) can’t make the payments on time. You need the money now – some of it, anyway. But, lucky you, you’ve bought a credit default swap (CDS) that pays you in the unlikely and unhappy event that Samara DEFAULTS on her debts – defaults even for a moment. (The terms of the contract are triggered by a so-called “credit event.”)

In other words, you bought INSURANCE against just such a default. And the only reason it wasn’t CALLED “insurance?” Because that industry is highly regulated, state by state, and Wall Street’s CDS issuers didn’t want stodgy old “government” to interfere with their snappy, seemingly profitable innovation.

But you’re NOT Sister Samantha. You’re Rich Hopen of Westfield, N.J. and Toyota is holding YOUR legal promise: the lease you signed. So why would it buy insurance against what we might call a “Hopen bond”? In case you renege on your lease – in effect, default. Practically speaking, the insurance is a Rich Hopen credit default swap.

But now comes the intriguing part of the story. Toyota insured the car, if your information is correct, for MORE than its market value (after subtracting the depreciation over the time you’ve had it). The question is: Why would anyone one SELL them such a policy at a reasonable price?

I don’t have time to research this, so I’m going to guess what happened: Toyota was betting the value of the Lexus would go down; the insurer was betting the opposite.

And if that’s right, it would illustrate the nature of the CDS market, and something quite worrisome, right at the moment, even if it has little to do with your Lexus (though it might suggest that you’ll be able to buy a much cheaper one soon enough).

The United States (or Sam Family: Uncle, Samantha, Samara, et al.) is borrowing more and more money these days, issuing barrel-loads of its legal promises in the process. As the world’s investors panic about every OTHER form of investment, they’ve been gobbling up these promises – U.S. Treasury notes, bills and bonds. The increasing popularity of the promises has meant that Family Sam can get away with offering less and less interest on the promises. And thus, interest rates have been going DOWN, even as the amount of promises has been going UP. Curious, no?

But wait. Let’s take a look at the CDS market. What’s happening to the cost of buying insurance against a Family Sam default? Hmmm…it’s going UP. WAY up. Back in the good old days, before Bear Stearns, Fannie and Freddie, Lehman, AIG, IndyMac, Wachovia – need I go on? – the cost of a five-year CDS or insurance policy that would pay in the event of a U.S. “credit event” was about .09 percent. That means an insurance policy for $1 million would cost you $900 a year and, as long as you kept up your payments, the policy would be in effect for five years. It also means, if you think about it in terms of odds, that the likelihood of a U.S. default, in any given year for the next five, was deemed to be less than 1000 to one ($1 million-$900).

So what’s the price of a U.S. CDS today? Something like .6 percent when I looked the other day. That’s SIX times the price of what it was in the good old days which, I hate to remind you, were LESS THAN A YEAR AGO. In gamblers terms: the odds of the previously unthinkable – the U.S. government defaulting on its obligations – have gone from 1000 to one to 130 something to one in about nine months.

I don’t want to terrify you. A “credit event” involving the U.S. government COULD be something as relatively benign, some think, as the failure of Congress to raise the debt ceiling temporarily. Whether or not such an event would qualify as a “default” would be decided by the courts, but a BUYER of a U.S. CDS could be betting on something of the sort – a technicality, you might say.

Moreover, when’s the last time you saw a 130 to one long shot come in?

Let me end with a piece of advice, Rich. Make a low-ball offer on the Internet – Craig’s List? eBay? – for the Lexus you want. And wait.

Editor’s Note: On an automotive sidenote, below you can watch an interesting clip from FRONTLINE’s two hour special, HEAT, on the Big Three’s attempts at fuel efficient cars in the 1990’s.