October 17, 2008
Credit Default Swaps – (CDS)
By Wade Rousse
Recently, if you’ve watched the news, read the paper, or even had lunch with your grandparents, you’ve probably heard the term “Credit Default Swap.” It sounds complex, but like many other terms in economics and finance, it’s not as hard to understand as it seems.
I think the term “swap” is what causes the problem. Think of these financial tools simply as “insurance” contracts that are designed to protect the bond holder from default.
Here’s an example: Suppose a company needs money to expand its operations. What can it do? Issue bonds! Now, suppose that you are an investor and you purchase one of these bonds. If, after making the purchase, you become concerned that the company will not be able to fulfill its obligation to pay you back, you can purchase a CDS from an insurance company or a hedge fund. Then, if the company defaults, you will be guaranteed the bond’s face value.
I’m confident the problems we are witnessing now in the CDS market will be solved. There’s no doubt that credit default swaps add value to the marketplace. Regardless, this is another concept that sounds very complex but really is not!
Posted by Wade at October 17, 2008 1:59 PM
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Since it is similar to an insurance contract, it should be treated like an insurance contract (i.e. you should not be able to purchase the insurance unless you have an "insurable interest" (i.e. you own the bonds))
Similarly, you should not be able to sell the "insurance" unless you are willing to set aside some of those "premium dollars" as a reserve. This would be similar to other insurance companies when they sell a policy.
Finally, there should not be a "secondary market" for these instruments. Each contract should be negotiated between a buyer of of the "insurance" and a seller. This way, when an original buyer wants to unwind his contract (i.e. he/she might no longer own the underlying bonds)it will not have a corresponding detrimental effect on the price of the underlying bonds.
Posted by: irishman at October 17, 2008 6:53 PM
Thank you. What regulatory agency oversees the operation of the CDS market? Wade, would you also explain more of the abbreviations I see and hear?
Posted by: Mike Fladlien at October 18, 2008 12:28 PM
The irishman makes some really good points. But, I’m curious. Even if the secondary market was tightly regulated, and only a small portion of the total CDS contracts were allowed to trade on this secondary market, do you think there still should be no secondary market? Wouldn’t this help price discovery?
Posted by: Wade at October 19, 2008 2:31 PM
My opinion regarding Wade's Oct 19 comment: Does any other insurance policy have a secondary market? In theory, a secondary market would offer "more efficient" price discovery. But if I want to buy an insurance policy for my bonds, I can discover price by requesting a bid from various insurance providers. After I purchase the policy, I should not care about the price. I am buying the policy for protection, not for market speculation. When I no longer need the protection, I will unwind the contract with my counter-party. Six months later, if the underlying company being "insured" is in distress. It is likely that new "buyers" of insurance will emerge. It is equally likely that the new buyers will have to pay more for the insurance. However, that should not give me the right to sell my insurance at a profit. The insurance should not be an investment, but rather "peace of mind." Similar to auto, life, and health insurance.
Posted by: irishman at October 22, 2008 9:57 PM
One more addition to my original comment (10/17)regarding the necessity to have an "insurable interest" in the underlying bond in order to buy the protection the CDS offers. Even if we allow 100 different people to buy insurance on the same house, that action does not drive down the value of the house(it might make it more likely that someone will burn the house down, but it does not have a direct impact on the value of the house). By contrast, if we have 1000s of different people buying CDS insurance on a corporate credit, it DOES have a direct impact on the price of that corporation's credit. As the corp. is seen as a more "risky" credit, it soon has a direct impact on that Corporation's stock price, and ultimately, as in the case of Lehman, it can be a self-fullfilling bet on the life of the corporation. This is "bad" insurance.
Posted by: irishman at October 23, 2008 2:01 PM
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Posted by: Filmy online at December 19, 2010 7:31 AM
Awesome post.Much thanks again.
Posted by: Mireille Fris at October 23, 2011 9:34 AM
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