A Credit Default Swap (CDS) transfers financial risk from one party to another. The buyer pays the seller’s premiums in exchange for the seller’s assumption of risk. However, the unregulated market for credit default swaps led to problems, including the inability of some sellers to cover their credit swaps.
A CDS (Credit Default Swap) is a contract that transfers financial risk from one party to another. In a credit default swap, the buyer pays the seller’s premiums for the life of the contract, in exchange for the seller’s assumption of risk. If the credit instrument involved in the default of the credit swap is radically devalued or suffers another catastrophic financial event, the seller will pay the buyer the face value of the credit instrument.
In simple terms, let’s say John borrows some money from Suzy. Suzy may decide that she doesn’t want to take the risk of bad debt, so she approaches Julian and negotiates a bad debt swap. Suzy pays Julian premiums in exchange for taking on the risk of the loan. If John successfully repays the loan, the contract is terminated. If, however, he decides not to pay, Julian must pay Suzy the face value of the loan.
The credit default swap concept was pioneered at JPMorgan Chase in the mid-1990s to allow banks, hedge funds and other financial institutions to transfer the risk of corporate debt, mortgages, municipal bonds and other credit instruments. By 2007, the market for credit default swaps had grown to twice the size of the US stock market, and because this sector was unregulated, some serious problems began to emerge.
One of the biggest problems with a credit default swap is that it is supposed to act as insurance, but it doesn’t, because the insurer, the seller, is not required to provide proof of the ability to cover the debt in the event of default. Also, the contract can be transferred; so while the original seller may have been able to cover the claim, people further down the line may not.
Going back to the example above, if Julian turns around and sells the contract to Mary and John doesn’t pay, Mary might not be able to pay Suzy. Mary might even sell the contract to another party, making it difficult for Suzy to track down the contract holder in the event of a default.
Trading this credit derivative product began to be recognized as a problem in 2008, when several financial firms, including the insurance giant AIG, realized that they were unable to cover their credit swaps. The problem was compounded by the US subprime lending crisis, as thousands of homeowners defaulted on their mortgages, putting severe pressure on the banking sector.
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