A Credit Default Swap Explained

[Yavin4]

Party B buys a bond from Party A, but Party B is worried that Party A will default on the bond.

Party B goes to Party C, a Swap Dealer, and makes the following deal. For a fee (or premium) from Party B to Party C, Party C will pay Party B if Party A defaults on the bond.

For some of these deals, Party C would re-pay the entire amount or a partial amount. It would depend on the size of the premium and the risk of the bond.

In the end, Party B has hedged their position on this bond because they're insured from default by Party C.

Party C in turns hedges their position by getting a default swap from Party D.


The major problem here is that the risk is never eliminated. It just gets passed to one Party after the other, and if one party cannot pay, then the entire system collapses.

[kirby]

1. That is the failure of the scheme...

Normally Party B does some due diligence research and if Party B worries that Party A will default, they do not do business with that person. End of Risk.

Instead, this CDS scheme encourages people to skip the due diligence part, accept a risky deal, and rely on Party C for insurance. The other problem is that Party C (like AIG) was excited that everyone would buy their new insurance for this stuff. They charged maybe $10 for $1million. That number was just made up and did not reflect a real cost.

[Yavin4]

2. Party B Wanted A Bond With A High Interest Rate

which is why they bought Party A's bond in the first place.

[kirby]

4. I dont think that is true...

And that is part of the problem. High Interest Rate means high risk which is a red flag. These transactions were on 'mortgage backed assets' meaning there was collateral. So the rates were not very high (6% maybe). The problem is that the collateral (a bubble priced house) is nowhere near enough to cover the transaction when the default occurs.

Chris Cox, SEC, said several times the other day during the hearing that noone regulates these CDS's and they need to be. Personally I think they should be outlawed.

[Yavin4]

8. Mortgage Backed Securities Are Different from Credit Swaps

A MBS is a security based on a basket, or tranches, of mortgages. The I-banks would buy mortgages from mortgage brokers and banks. Bundle them together, and assign them to a SPV (Special Purpose Vehicle). The SPV would then issue securities, and the bank would be on the hook for them if the mortgages did not pay off.

A CDS is something that people use to hedge faulty credit. These things can make a lot of money, but they can also lose a lot of money. The problem is that no one can really knows the full extent of their risk exposure. That's where regulation falls down because these banks are not required to disclose their full risk exposure to these derivatives.

[Skink]

3. Then a catagory 5 Hurricaine hits NY wiping out the reinsurance industry.

[BlooInBloo]

5. Couldn't just say the word "insurance" could'ja?

:rofl:

[kirby]

6. No because insurance is regulated, so invent a new name for the same thing! n/t

[BlooInBloo]

7. "Insurance" is a somewhat larger word than perhaps you're thinking....

Take blackjack, for example.

[kirby]

9. Even gambling is regulated ;) n/t

[BlooInBloo]

11. Not when I play it isn't. And we still call it insurance....

Along with the other 10 brazillion people who play unregulated blackjack.

[Yavin4]

10. Bond Insurance Probably Carries Different Regulation

The bond insurance business is regulated and requires fuller disclosure.

[krkaufman]

12. And then add-in that the relative risks were obscured/hidden as the swap pyramids were built. n/t