30 Jun What is a Credit Default Swap? And Why Should You Care?
A credit default swap is a kind of insurance. It’s also like a ticket for a bet on a horse race — a bet on which horse will lose.
A CDS is a simple idea. In its most basic, safe form, it’s a way to hedge the risk of a loan failing. If a bank loans money to you, it can buy a CDS from an insurance company or other financial player. The CDS will payoff in the event you do not. It swaps the risk of a credit (the loan) defaulting to another party in exchange for a premium. In its best form it is no more or less than insurance. The lender is willing to take slightly greater risks in lending because a third party is willing to, in effect, act as a guarantor of your loan. That guarantor of course will set the price of its insurance based on how much risk they believe you present. So in theory a CDS on a very risky loan will be so expensive to buy, that the lender might not want to make the loan in the first place because there’s no way to “hedge” it.
So how is a CDS also like betting on losing thoroughbreds? There’s no obligation that someone buying or selling a CDS have any interest in the underlying transaction. In other words, you don’t have to be the lender or borrower, or involved in the underlying deal in any way, to buy or sell a CDS on a given credit transaction. You don’t have to own the horse to bet for or against that horse.
Ironically, as many have pointed out lately, credit default swaps were actually illegal under the gambling laws of most states until federal law was changed in 2000 to make it lawful. The irony is more frightening when you notice there is little requirement that someone writing a CDS maintain enough capital to pay off the swaps if the unthinkable — say the collapse of the American real estate market — came to pass. Bad bets on these swaps — and the fear of the ramifications of the collapse of the CDS market — are largely to blame for the multi-billion dollar taxpayer investment in AIG among other institutions.
This is not the only way consumers are affected by credit default swaps, though. CDS bets have been made (and continue to be made) against consumers and businesses across the economy. There are swaps betting on whether companies will be able to pay back their bonds, whether foreign governments will be able to meet their debt payments, and there’s probably a CDS written betting against you being able to make your credit card, student loan, or mortgage payments.
These bets are still mostly unregulated, underreported, subject to manipulation, and has the potential to encourage large financial players to actually undermine the economy.
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