Credit default swap

A credit default swap (CDS) is a credit derivative contract between two counter parties, whereby the buyer makes periodic payments to the seller in exchange for the right to a payoff if there is a default or credit event in respect of a third party or reference entity.

A credit default swap (CDS) is a swap contract in which the buyer of the CDS makes a series of payments to the seller and, in exchange, receives a payoff if a credit instrument (typically a bond or loan) goes into default or on the occurrence of a specified credit event (for example bankruptcy). Credit Default Swaps can be bought by any investor; it is not necessary for the buyer to own the underlying credit instrument.

A CDS is like a Health insurance policy that we may take to cover up for the cash requirements if we get any health problems. We pay a premium to the insurance company and if we get any health problems, the insurer would pay for the medical treatment.

Let us take into example what happened in the US Markets:

The Investment bank that bought the subprime loans contacted Insurers like AIG and created swap agreements with them. They would be making periodic payments to AIG over the span of the loan tenure and if anything unexpected happens and the loan is defaulted the Insurance company would pay the amount to the Investment bank.

Here the Investment Bank does not own the Loan but still it has entered into CDS agreements with the insurance company to save itself in the event of loan default.

The Price or Spread of the CDS is the amount that the investment bank would pay to the insurance company in return for the protection. Say if the spread is 0.5% or 50 basis points (one basis point = 0.01%) for a protection worth Rs. 10,00,000/- then the investment bank would pay the insurance company a premium of Rs. 5000/- every year. This payment needs to be made until the CDS agreement is in force or the loan becomes defaulted.

If the Spread of a CDS is higher, then it effectively means that the probability of default of the CDS agreement is more than normal since they are being charged a higher premium amount.

The Market for CDS Instruments:

Credit Default Swaps are by far the most actively traded Credit Derivatives product. There is no centralized exchange or clearing house for CDS transactions; they are all done over the counter (OTC). This has led to recent calls for the market to open up in terms of transparency and regulation

You may be wondering why would insurance companies enter into CDS agreements. The reason is Simple. Default is considered as a rare occurrence. Insurance companies expect only 0.2% of all CDS contracts to default every year. So most of the payment is only one way.Their assumption is what spelt their DOOM...

The Downfall:

Critics of the huge credit default swap market have claimed that it has been allowed to become too large without proper regulation, and that because all contracts are privately negotiated, that the market has no transparency. Furthermore there have even been claims that CDS's exacerbated the 2008 global financial crisis by hastening the demise of companies such as Lehman Brothers and AIG.

When the Housing bubble burst, people started defaulting on Loans. The Banks were unable to make the payments to the investment banks who converted their Loans into MBS. The Investment banks in turn went to the insurance companies to cash in their CDS contracts to save their losses. When the claims exceed the total premium collected, no insurance company would be able to survive. This led to the downfall of insurance giants like AIG and the government had to intervene and save it.