Thursday, July 31, 2008

Credit Default Swaps: Easy Money through Complexity?

Often referred to as a sophisticated form of credit insurance that’s an easy source of big money for the financially savvy, that is until greedy speculators used them to cash in on the US subprime mortgage crisis. Green backs from Red Tape?

By: Vanessa Uy

Financial regulators now bemoan the existence of Credit Default Swaps or CDS. Some even say that trading in Credit Default Swaps ought to be crime because of the way it siphons the hard-earned money of less investment savvy folks into the coffers of greedy speculators. This almost criminal practice of earning big money easily was recently highlighted by the financially savvy purchasers of homeowners insurance who opted for Credit Default Swaps to hedge their risks, which unfortunately created a “domino-effect” that led into the US credit crunch and the subprime mortgage crisis. Because of this, majority of US banks and other financial institutions no longer trust the credit worthiness of their fellow “financial institutions” due to the effects of the unregulated trade in Credit Default Swaps. But in order for us to form a sound judgment over Credit Default Swaps, let us first define what it is.

A Credit Default Swap or CDS is a credit derivative – i.e. financial instruments of special nature – dealt between two counterparties. One party makes periodic payments – usually in the form of insurance premiums – to the other and receives the promise of a payoff if a third party defaults. The former party receives credit protection via credit insurance and is said to be the “purchaser”. The other party provides credit protection and is said to be the "seller”, while the third party is known as the “reference entity”. For all intents and purposes, Credit Default Swaps are nothing more than privately traded insurance contracts that let people bet on a certain company’s financial health.

When it comes to credit derivative products, Credit Default Swaps are the most widely traded. The usual term of maturity of a CDS contract is five years. But because it is a derivative that’s dealt over-the-counter, Credit Default Swaps of almost any maturity can be traded.

As credit derivatives go, Credit Default Swaps are a relatively recent development. Back in 1995, Blythe Masters of JP Morgan developed the first Credit Default Swap and Collaterized Debt Obligations even though other bond insurance products are already available since the 1970’s. When Blythe Masters was heading the Global Credit Derivatives group of JP Morgan, he introduced Credit Watch in April 2, 2007 as a regulatory measure and also to help evaluate credit swaps among other financial instruments. By the end of 2007, there is an estimated 45 trillion US dollars worth of Credit Default Swap contracts. But if the inherent regulatory measures are well established, then what’s the problem?

The problem with Credit Default Swaps occurs when they hit the market. Everyone knows that banks and insurance companies are regulated, while the credit swaps market is not. Because of this, contracts can be traded – or swapped – from investor to investor without any regulatory body overseeing the trades to ensure the buyer has the resources to cover the losses if the security defaults. The instruments can be bought and sold from both ends – the insured and the insurer – with nary an oversight. Thus your typical greedy speculator has now been granted “free reign” to prey upon the financially ignorant and those with gullibility for get rich quick schemes. For all intents and purposes, the current market in credit derivatives has now become Mephistopheles’ playground due to lack of regulation and oversight. Thus perpetuating our current financial crisis in which these forms of credit insurance were built to prevent in the first place.

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