October 7, 2008, 6:00 am

Behind The Financial Crisis: Credit Default Swaps

by: The Financial Blogger    Category: Banks and You,Investment, Market and Risk,Trading
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Are we going to see US banks close on after another for long? Unfortunately, nobody has the answer for this question. However, we can now try to understand how come an insurance giant such as AIG could tumble that fast. A part of the answer lies in the Credit Default Swap (CDS) market. In fact, I believe that this type of product could be an important player in the financial crisis.

What is a Credit Default Swap anyway?

By definition, a CDS is an instrument intended to cover losses to banks and bondholders when companies fail to pay their debts. Therefore, it is a hedging tool for people or institutions holding bonds. At first glance, this seems to be an interesting and safe product since it’s a type of insurance.

On one side, we have the CDS buyer who could be a speculator (hoping that the bond issuer goes bankrupt) or a bondholder. On the other side, we have the insurance seller who could be an insurance company, a bank or a hedge fund. By the way, AIG was one of the big players in the credit default swap market.

So far so good, we have an insurer and a client. However, the problem appeared when financial geniuses created a secondary market for credit default swap. Therefore, the insurer was able to sell its insurance to other financial institutions.

So insurance contracts were being sold and resold on the market and everybody was throwing more CDS on the market in order to sell them. The market capitalization of credit default swaps jumped to 45 trillion in 2008 compared to 21 trillion for the US stock market and 7 trillion for the mortgage securities market. This is quite impressive for an insurance product isn’t?

Meanwhile, the insurance seller had now more money and his pocket and decided to lend this money into the sub-prime market (selling insurance on those loans of course!). They were snowballing debts and insurances all together and obviously making enormous profit while people were paying their dues.

So the problem started when companies or individuals stop paying their debts. Insurance buyers were first assured that they would get their money back until they discover that the company who sold them the insurance is no longer responsible of the insurance. They then have to track down the current insurance policy holder to find out they could not pay them back anymore.

This is where the domino effect took place and put everybody in a very uncomfortable situation. When people lose their confidence in the market, in the financials, everything goes wrong. This is probably why the FED is going with such extreme measures to re-establish the confidence in the market and stop this madness.

I hope that we will learn from this sad experience and that we will reinforce laws on financial products!

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Comments

Nice post, except the following:

“The market capitalization of credit default swaps jumped to 45 billion in 2008 compared to 21 billion for the US stock market and 7 billion for the mortgage securities market.”

I’m hoping you meant trillion instead of billion.

Do you have a Private mortgage insurance (PMI) policy? If you do your PMI insurer has passed along their risk by buying a credit default swaps (CDS) to protect them in the event you have your home that your home is taken away from you. CDS and PMI are the same thing. Make people wanting to buy a home put at least 20% down if you don’t like them. nomedals.blogspot.com

by: The Financial Blogger | October 7th, 2008 (4:28 pm)

Nelson,

you are right, that’s the problem when you think in French and write in English 😉

by: The Financial Blogger | October 8th, 2008 (6:12 am)

Jason,
I totally agree with you. In Canada, they canceled the 40 years amortization and 0% cash down mortgages. Hopefully we will reach an equilibrium… fast 😉

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