Credit default swaps

From MarketsWiki

Simply put, a credit default swap (CDS) is similar to an insurance contract, providing the buyer with protection against specific risks. In a CDS, one party (the protection buyer) pays a periodic fee to the other party (the protection seller) in return for compensation for a default or similar credit event by a third party. The third party is not a party to the credit default swap.

The protection buyer gives up the risk of default by the third party, and takes on the risk of simultaneous default by both the protection seller and the third party. The protection seller takes on the default risk of the third party, similar to the risk of a direct loan to that party.

Credit-default swaps are traded on the over-the-counter (OTC) market and used to speculate on a company's ability to repay debt. They pay the buyer face value in exchange for the underlying securities or the cash equivalent should a borrower fail to adhere to its debt agreements. A rise indicates deterioration in the perception of credit quality; a decline, the opposite.^[1]

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Corporate bond investors often buy credit default swaps for protection against a default by the issuer of the corporate bond. A CDS can be used in many ways to customize exposure to corporate credit.

CDS contracts can mitigate risks in bond investing by transferring a given risk from one party to another without transferring the underlying bond or other credit asset. Before credit default swaps, there was no vehicle to transfer the risk of a default or other credit event, such as a downgrade, from one investor to another.^[2]

The market for CDRs has been huge. It is estimated to be between $45 and $62 trillion. ^{[3] [4] [5]}

Credit default swaps have been widely criticized as playing a crucial role in the 2008 credit crisis. Unlike traditional insurance, the swaps are unregulated. Warren Buffett famously called them "financial weapons of mass destruction."^[6]

During the 2008 crisis, the NY Federal Reserve Bank called for market participants to submit a cleared facility solution for CDS contracts before the end of 2008. The bank is expected to choose a clearing platform for that market from a number of potential candidates including, CME Group which has a partnership agreement with Citadel to execute and clearing CDS contracts. Other interested organizations include Intercontinental Exchange, NYSE Euronext, The Clearing Corporation and Eurex.^[7]

History

As investment banks evolved they began creating more and more complex financial products, including credit default swaps. Trading in these swaps exploded on Wall Street, eventually reaching as much as $62 trillion in credit default swaps outstanding.

Companies like AIG began not only insuring houses, but also insuring the mortgages on those houses by issuing credit default swaps.

American International Group (AIG)'s collapse was thought to stem from a $441 billion exposure to credit-default swaps and other derivatives.

On Oct. 9, 2008, an auction for CDS contracts held by investment bank Lehman Brothers, which filed for bankruptcy on Sept. 15, was held.

References

1. ↑ Credit Seizure? $6 Million Pay Turns on Relationships. Bloomberg. Retrieved on October 1, 2008.
2. ↑ Credit Default Swaps. PIMCO. Retrieved on July 28, 2008.
3. ↑ credit default swaps. The New York Times. Retrieved on October 23, 2008.
4. ↑ SEC's Cox says supports merger of agency, CFTC. Reuters. Retrieved on October 27, 2008.
5. ↑ Credit Seizure? $6 Million Pay Turns on Relationships. Bloomberg. Retrieved on October 27, 2008.
6. ↑ The Bet That Blew Up Wall Street. CBS News. Retrieved on October 27, 2008.
7. ↑ NY Fed calls Friday meeting for CDS players. Reuters. Retrieved on October 8, 2008.