Understanding Credit Defaut Swaps and their impact on your investments

bee

Just another boring important topic...

If one has in a car, a house, a family it is common sense that one would also have insurance on these things. We don't think twice about insuring these "assets" against a catastrophe. In all of these circumstances we buy insurance to insure against damage to property as well the possibility of disability or death to an individual. One common way a bond holder insures its bond investment's risk is with the purchase of Credit Default Swaps (bond insurance).

If the bond holder were the only party insuring against potential loss (risk) than a lot of what went wrong in 2008 through today would not exist. But, instead there is no regulations against other parties taking out insurance policies on a bond's failure. Anyone can bet against a bond and hope it defaults. The problem came when bonds were knowingly built to fail. Lets say, I create a high risk bond (say a collection (pool) of sub prime mortgages full of liar loans). I sell this bond investment to unsuspecting (naive) investors (individual, insurance companies, pension funds, etc). Then finally I take out a CDS (insurance policy bet) that this investment would fail. I have no stake in this investment other than I sold it to someone at a profit. Through the power of leverage I can put a very small wager (insurance bet) that if it fails (when it fails) the insurer of the CDS (an company like AIG) will have to pay out large sums of money to me and multiple other parties (my friends) that bet against these bonds. Oh yeah, did I mention that these bonds were AA rated before they blew out on the highway and all the occupant of the bond (women and children) were in the bond at the time?

When Ford allowed faulty tire to be installed on their SUVs a few years back there was hell to pay for death and damage that these tires caused. We have product recall on all kinds of faulty manufactured goods, we should have product recall and liability on faulty investment products. A CDS is an important product for the owner of the bond especially if it is a low rated risky bond. But CDSs should not be something other parties gamble on hoping... no worse...orchestrating...insuring...their failure. Harm caused through purposeful intent.

That's for the lawyers and regulators to get rich arguing out. Hopefully they do.

Anyway, here's a couple of read for those who have braved these few boring paragraphs. Uninterested? That's what they are hoping...we are too bored to care.


Present outlook on CDS:
http://blogs.worldbank.org/prospects/category/tags/cds-spreads

The Economics of CDSs:
http://kamakuraco.com/LinkClick.aspx?fileticket=Mvp5AadRwGo=&tabid=208&mid=735

Everything You Wanted to Know about Credit Default Swaps--but Were Never Told:
http://www.aei.org/outlook/29158

catch22

Hi bee,

I receive several mails each day related to CDS values. I do watch these.

No wondering why these devices are not named "insurance contracts"; which could cause them to be "regulated", eh???

I am not sure if this is the same video link I posted at FA a few years back; but if not the same one, there are many other similar explanation videos at youtube with the search words of cds explantion .



Thanks and take care,
Catch

scott

I think my concern is what if Greece or another country defaults and it's not a "credit event" for one reason or another. I think the counter-party aspect of these sorts of derivatives is going to continue to be problematic going forward and I really think when it comes to sovereigns that the people holding this insurance are going to wake up one morning thinking that the insurance is going to pay off, only to find that the rules have been changed/tweaked.