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Friday, October 10, 2008

What are credit default swaps?

There is a lot of mention currently in the media regarding credit default swaps. Here is our explanation on the credit default swaps, and why are they such a problem in the current market.

What are credit default Swaps?

The credit default swaps are unregulated contract that is approximately $62 trillion market. Currently, these contracts are blamed for the market volatility, as well as, downward spiral of American Insurance Group(NYSE:AIG) and Lehman Brothers(NYSE:LEH). Along with that, there is a lot of political, government and economical posturing going on to save the troubled financial institutions. So the question that comes to mind:

What are credit default swaps ?

Credit Default Swaps involve a large investor who buys a bond, but is worried that the company will not be able to pay off the bond. It investor who wants to participate in that particular bond market, but wants to manage the default risk. To manage that risk, the investor goes to, for example, AIG, and buys protection or insurance. This protection or insurance is called a credit default swap. The insurer, like in our example AIG, gets a fee for provide that protection to the investor. The investor in return gets the protection he/she wants.

There are some unique characteristic of these credit default swaps that are important to know, in particular, the unregulated nature of them. Below are some of them:

  • The transactions is what is called an “over the counter” transaction. What this means that the transactions is NOT regulated by any public exchange.
  • These contracts are not considered, in legal terms, an insurance. So the companies, like AIG, that guarantee the bonds are not required to keep adequate capital to pay them off in the event of a default. So basically the companies that are providing the insurance are not required to have the money to effectively provide that insurance.
  • Because the insurance does not have the money in their “banks” to provide the guarantee, the investor who has bought the protection gets a false sense of security. The investor thinks that he is managing the risk of default but, in actuality, he is not because his insurer does not have the ability to pay.

So now we know the characteristic of these credit default swap, how did it cause the current turmoil ?

When the house prices where rising, the mortgage market were good places to invest money for pension funds and other institutions. The investors, like hedge funds and pension funds, invested in the mortgage market. To manage the risk of these investments, bought the insurance provided by the credit default swaps issuers. The investors did not realize that these companies do not have the ability to pay in case of the massive mortgage defaults. In fact, the management of insurance provider did not do good due diligence to account properly for the risk associated with such a melt down.

The investors kept on making more and more investments in the mortgage market because of attractive returns and this false sense of security provided by bond insurers like AIG.

So how did the house of cards fall ?

When the house prices declined, and the mortgage default rate begin to rise, the investors went to insurers to call on the protections that they had bought. The investors who went to insurers, suddenly faced the probability that the insurance providers may not be able to pay. So, the investors, who cannot recoup their losses, where left hanging. The insurance providers or insurers faced bankruptcy because they could not fulfill their obligation.

Thus, the house of cards. Analysis - Conglomerates Analysis - Basic Materials