Credit default swaps

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Credit default swaps (CDS) are financial instruments intended to provide risk insurance to banks and bondholders in case a particular bond or security goes into default (when there is not enough revenue behind the loan to meet the promised payments). Their purpose is to make it easier for banks to issue complex debt securities by reducing the risk to purchasers. They were invented by Wall Street in the late 1990s.[1]

In a CDS, a buyer of protection pays an insurance premium to a protection seller who agrees to cover any lost interest or principal on bonds or loans issued by companies, countries or other organizations. The buyers and sellers are typically securities firms, hedge funds, banks and insurance companies.[2]

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.[3]

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.[4]

The market for CDRs has been huge. It is estimated to be between $45 and $62 trillion. [5] [6] [7]

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."[8]


History

According to Richard Zabel, a forensic accountant at the law firm Robins, Kaplan, Miller & Ciresi LLP, the CDS market was created by commercial banks that wanted to transfer risk off their books and free up regulatory capital. By buying CDS protection, banks were able to shift default risk to a third party and thus reduce the amount of regulatory capital they had to set aside against debt holdings.

At first the market grew slowly, but it began to expand exponentially once market participants realized they did not have to own the bonds to buy insurance against their default. Instead, purchasing a CDS contract allowed a participant to speculate on the possibility of a bond issuer's defaulting, effectively creating a shorting opportunity. The movement from hedging usage to speculation usage led to explosive growth of the market and helped create a secondary market in CDS which added to speculation in the instruments. According to Moody's Investors Service, about $62 trillion of debt was protected by CDS contracts at the end of 2007. [9]

Adding complexity to the market, sellers of CDS contracts, to hedge against default, will often themselves buy protection for the debt they insure. This allows them, in the case of default, to collect insurance at the same time as paying it out, greatly limiting the resulting loss. The insurer thereby also becomes the insured.[10]

Companies like American International Group (AIG) began not only insuring houses, but also insuring the mortgages on those houses by issuing CDS. Eventually, AIG racked up a $441 billion exposure to credit default swaps and other derivatives. Although an isolated default would not necessarily have posed a great risk to the market as a whole, the default of a major dealer such as AIG had the potential to bring about systemic damage beyond just the CDS market. CDSs, like other OTC derivatives, are bilateral contracts without a centralized clearing platform, so it was impossible to gauge any party's total exposure.

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. In March of 2009, New York Insurance Superintendent Eric R. Dinallo added to calls by U.S. regulators to make it compulsory for trades in the $28,000 billion credit derivatives market to be cleared centrally. Dinallo said in a piece published in the Financial Times that credit default swaps were the major cause of the collapse of insurer AIG. (Dinallo's department regulates insurance arms of AIG but not its financial products division.) Dinallo also said that making it compulsory for CDS to be cleared via a central clearing counterparty was one way to ensure there was sufficient capital behind the transactions.[11]

Intercontinental Exchange Inc began clearing CDS in March 2009, after it acquired The Clearing Corporation in order to do so. Its rival, the CME, partnered with Citadel Investments, is also vying (along with several other exchanges) to clear CDS. Regulators approved CME's clearinghouse in March 2009, but the CME has not yet launched it, partly because it has not yet struck agreements with additional partners in the venture.[12]

References

  1. Times Topics: Credit Default Swaps. The New York Times.
  2. Surprises in a Closer Look at Credit Default Swaps. The New York Times.
  3. Credit Seizure? $6 Million Pay Turns on Relationships. Bloomberg.
  4. Credit Default Swaps. PIMCO.
  5. credit default swaps. The New York Times.
  6. SEC's Cox says supports merger of agency, CFTC. Reuters.
  7. Credit Seizure? $6 Million Pay Turns on Relationships. Bloomberg.
  8. The Bet That Blew Up Wall Street. CBS News.
  9. The Abyss. The Deal Magazine.
  10. The Abyss. The Deal Magazine.
  11. Dinallo adds to watchdogs' calls for compulsory central clearing of CDS. FT.com.
  12. CME says CDS clearing still up for grabs. Reuters.