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Credit Default Swaps and the Financial Crisis

Posted on | August 30, 2009 | No Comments

A credit default swap is a contract between two parties in which the buyer makes periodic payments to the seller and in return received a payout when the financial vehicle defaults.  From wikipedia.org, here is an example

“As an example, imagine that an investor buys a CDS from AAA-Bank, where the reference entity is Risky Corp. The investor will make regular payments to AAA-Bank, and if Risky Corp defaults on its debt (i.e., misses a coupon payment or does not repay it), the investor will receive a one-off payment from AAA-Bank and the CDS contract is terminated. If the investor actually owns Risky Corp debt, the CDS can be thought of as hedging. But investors can also buy CDS contracts referencing Risky Corp debt, without actually owning any Risky Corp debt. This may be done for speculative purposes, to bet against the solvency of Risky Corp in a gamble to make money if it fails, or to hedge investments in other companies whose fortunes are expected to be similar to those of Risky.”

This is something that was very popular through the subprime mortgage crisis and many people think this is a large cause of the credit crunch.  I personally believe bad credit loans are the main reason for the financial disaster but that is up for debate.

Investopedia defines a credit default swap as

“The buyer of a credit swap receives credit protection, whereas the seller of the swap guarantees the credit worthiness of the product. By doing this, the risk of default is transferred from the holder of the fixed income security to the seller of the swap.
For example, the buyer of a credit swap will be entitled to the par value of the bond by the seller of the swap, should the bond default in its coupon payments.”

There is a great article from Time Magazine from back in March of 2008 talking about the next financial crisis located here.  This article was pretty prophetic because much of this stuff actually did happen and this is why we saw such a fall out in September of 2008.

CNBC is going to be having month long documentaries on the worst month in the history of the financial industry all month!  I hope you are as excited as I am to look back on what will go down in history as one of the worst months we ever life through.

Author: Heather Best

Category: Uncategorized

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