What is a credit default swap?

by Manshu on October 15, 2008

in Articles

Credit Default Swaps are going to become a household name all over the world for the wrong reasons. They will be known as the instruments that caused the second great financial crisis of the 21st century (after the dot com bust).

The total value of credit default swaps market is estimated to be around $58 trillion (Sep 2008).  To put that in perspective, the size of the global GDP was $54 trillion dollars in 2007. So, these instruments have a notional value which is greater than the GDP of the whole world!

Take a second to digest that.

Credit Default Swaps are derivative instruments which derive their value from the credit instrument they have been written for. The purpose of a credit default swap is to transfer the risk of the credit instrument from one party to the other.

A bank that has given out a mortgage to someone bears the risk of the default on mortgage payment. By using a Credit Default Swap instrument, the bank can transfer this default risk to the seller of the instrument.

A hedge fund, bank or any other financial institution will offer to sell the credit default swap to the mortgage issuing bank. The mortgage issuing bank will pay a premium for the credit default swap, much like an insurance premium.

If there is no default on the house loan, the bank has paid the premium for nothing. If there is a default, then the bank is protected as the seller of the credit default swap bears the risk.

This sounds much like an insurance product, but the key difference is the lack of regulation on credit default swaps, whereas insurance products are generally well regulated.

As long as house prices kept going up, everything was fine, but when the prices started to fall it set in motion a chain reaction which brought everything down like a pack of cards.

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