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Credit default swaps, or CDS, are insurance against the risk of default on a debt (such as loan, bond etc.). The writer (seller) of these swaps receive regular payments from the buyer (in most cases, in addition to an upfront payment), and in turn assumes the risk that the underlying debt will not be repaid. In the event of default, the seller of the contract has to reimburse the buyer for the unpaid interest and the principal of the debt.^[1]

Credit default swaps are non-standardized private contracts between the buyer and the seller. They are not traded on any exchange, and have remained unregulated by any government body. The International Swaps and Derivatives Association estimates the total amount of outstanding credit default swaps to be around $ 62.2 trillion, making these contracts the most widely traded credit derivative product, as of December 2007.^[2]

Due to the lack of regulation in the market for CDS, these instruments had been underwritten by almost any financial institution. Large insurers such as American International Group (AIG) and Ambac Financial Group (ABK) have been major players in the market in the past. However, such contacts are also written by hedge funds, mutual funds and banks such as Merrill Lynch (MER), Citigroup (C) and Morgan Stanley (MS).

[edit] How Credit Default Swaps Work

Credit default swaps have a buyer who pays a seller in exchange for protection against default on a loan.

Size of the CDS market ^[3]

Typically, payments (i.e. the seller would have to pay the buyer) under a CDS would only be triggered by the company’s failure to pay interest or principal on its debts due to bankruptcy or some other severe liquidity issue. But there are a host of intermediate or special cases that will doubtless provoke lawsuits when something goes wrong.

For example, suppose an investor owns a corporate bond from Apple that yields 8%. The investor is exposed to a number of risks that could lead to default (e.g. the bond issuer goes bankrupt). In order to protect himself, investor purchases CDS on Apple bonds from AIG on this bond. In exchange, he agrees to pay out a portion of the bond's yield to AIG. Now, for some reason, if Apple is unable to pay its interest on the bond, AIG has to pay the CDS holder the entire par value of the bond.

Credit default swaps were sold to the world as hedging transactions. Investors were told that they were simply transfers of risk, so that banks that made loans could transfer credit risks to insurance companies, which did not make loans directly, or to foreign banks that could not easily make loans in the U.S. market.

If an investor buys a CDS from a financial firm with good credit, the CDS does indeed act as a hedge against default risk.

[edit] What is the purpose of a CDS?

In exchange for the protection against default, the insurer receives a regular payment from the buyer. This is typically a percentage of the coupon payments on the bond. Effectively, while the buyer receives protection, he gives up a portion of his interest receipts to the insurer.

CDS does not have to be bought in conjunction with the underlying bond. Since, in the event of a default, the writer of the CDS reimburses the buyer the entire principal amount, these contracts can be used for speculative purposes. For example: if an investor believes that Lehman Brothers (LEH) would be unable to pay its creditor, he could just buy a CDS to bet on this position. This has led to use of these swaps for speculative activities.

[edit] Risks of CDS

A credit default swap comes with the risk that that the writer of these contracts will actually be able to settle the debt on behalf of the defaulting company. Prior to September 22, 2008 CDS were largely unregulated -- this meant that anyone could write such a contract given that the buyer thought they were credit-worthy. However, due to the 2007-2008 credit crisis, the New York Fed has announced that it would start regulating CDS contracts in New York. While the details of this regulation are being drafted, experts suggest that this would require CDS writers to prove to the New York fed that they would be able to settle the contracts in the event of a default. ^[4]

There are two sources of likely loss on CDS:

• Default by the underlying borrowers, the companies that originally took out the loans.
• And default by the banks or other financial firms that bought the credit default swap - counterparties in the endless chain of banks, insurance companies, hedge funds and general riff-raff that have done these deals.

Additionally, any event related to the underlying debt can affect the value of the CDS. For instance, leveraged buyouts can lead to a decreased value for these contracts since the acquirer takes on more debt to finance the buyout -- leading to an increased risk of default.

[edit] Further Reading

For detailed explanation of credit default swaps and how they are used please see What Are Credit Default Swaps and How Do They Work? courtesy of bond giant PIMCO.

Here is nice video from CBS explaining more about the Credit Default Swaps [1]

[edit] References

1. ↑ Wikipedia.com, Retrieved Sept. 22, 2008
2. ↑ ISDA Market Survey Historical Data, Retrieved 9/22/08
3. ↑ ISDA Market Data Historical Survey ISDA Market Data History
4. ↑ Bloomberg.com Sept. 22, 2008