The Cost of Credit Swaps When a Nation Defaults

Jamie Dimon was all about reassurance on July 14 as the chief executive officer of JPMorgan Chase announced second-quarter earnings. He said that the bank’s gross exposure to sovereign and other debt in Greece, Ireland, Italy, Portugal, and Spain was $100 billion. Its net exposure, Dimon said, was only $15 billion. The difference? Collateral posted by borrowers, which it can seize in a default, offsetting loans, and credit default swaps—insurance that pays off when a borrower defaults.

Credit default swaps are a source of pride for Dimon. His bank invented CDS in the 1990s and is the world’s largest dealer in them. Hedging with credit default swaps allows JPMorgan to keep lending in Europe, Dimon said: “We’re not going to cut and run.” Yet credit default swaps, like any insurance, are only as reliable as the company promising to pay. If the banks that sell protection to each other all start to suffer loan losses, they’re like drowning men offering to save each other. Keeping the benefits of swaps while reducing their potential for trouble is tricky business. Regulators are only partway to a solution—and some fixes could make matters worse.