Understanding Credit default Swaps

Imagine a market where you can trade your perception of someone else's credit worthiness. Imagine a market where you can encash an insurance policy on an asset gone bad without owning the underlying asset itself. Imagine a market which is larger than the capitalization of New York Stock Exchange and is yet not regulated. Welcome to the world of Credit Default Swaps (CDS).

The Instrument: The Credit Default Swap market is massive, estimated to be in excess of $50 trillion. CDS are derivatives, ie financial contracts without the underpinnings of any actual assets. They are used to bet on the credit worthiness of a loan or debt instrument. The price of the swap moves in line with perception of the borrower's credit worthiness. A swap seller believes that the borrower's ability to repay the underlying loan will improve while a swap buyer seeks protection against the possibility of a loan or bond failing. Almost all players in the financial markets are involved in trading CDS be they banks, hedge funds, Insurance companies, mutual funds or pension funds. It is estimated that over 30% of the volumes of CDS markets would be on account of hedge funds. CDS were initially devised as a means of hedging loan default risk by banks in USA. Since then they have grown to cover bonds, corporate loans, CDOs (collateralized debt obligations), auto loans, junk bonds, credit card delinquencies and all sorts of debt securities. CDS can be structured on individual company debt or can be based on baskets of mix of securities or baskets of similar securities with varying risk profiles.

It is this very flexibility that makes CDS fascinating. The fact that it can be structured as per the requirements of the buyer and the seller and can be customized to cover the risk and offer protection being sought by the buyer makes CDS a prudent risk management tool.

Driven by global liquidity: However, with the massive amounts of liquidity injected into the  system by the then Fed Chairman, Alan Greenspan, the advent of 2003 saw a significant decline in defaults on instruments of all sorts. The premium earned by hedge funds, who were a significant seller of CDS instruments, became a near riskless and lucrative source of profits in view of negligible defaults.

Sub-Prime assets: Very soon the path of CDS intersected with a reckless mortgage industry in the USA which was busy fuelling the upward spiraling home prices in the USA by bringing in home buyers with dubious credit history through innovative home loan instruments which created the optical illusion of highly priced homes being affordable to many. Borrowers with dubious credit histories and poor balance sheets got home loans creating the much maligned sub-prime category of loans. Then the ingenuity of human hubris took over and led to the creation of an out of control and spiraling circle of greed which now threatens the very banking system which created it.