Friday, January 16, 2009

Primer on Credit Default Swaps

The global financial system developed a method for insuring institutions against a plethora of new risky investments that sprang up in recent years.

The most common form of insurance was the credit default swap (CDS) that was commonly sold alongside risky investments, such as subprime mortgage securities.

A bank buying such securities would take out a CDS contract with another bank that would promise to cover the cost of the investment going bad in exchange for a regular fee.

These instruments were called "risk swaps" rather than insurance policies to remain free of such regulations that required the policy issuer to put aside enough capital to cover a default payout.

Invented primarily as a means of hedging against risk, the instruments took on a new life when they began to be issued and traded as a bet against institutions folding and defaulting on their obligations.

If a company looked like it was in trouble, Bank A could pay a fixed sum to Bank B to insure it against the company going bust. If that happened, Bank B would pay Bank A for the outstanding liabilities the company could no longer afford to honour.

This transaction could occur even if Bank A had no exposure to the company.

The unregulated nature of the trade means that nobody knows exactly how many such instruments are in the marketplace, who issued them and who holds them. Voluntarily released data shows the volume to be worth between $50-55 trillion.

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