Question

What is a credit default swap (CDS)? What “credit events” might trigger a payout? Explain how the CDS market influenced the crisis of 2007-2009.

Answer 1

Credit default swap is a contract which allows an investor to swap his credit risk with another investor. If a lender expects there is a chance that the borrower may default, lender can use this contract and transfer the risk of default to another investors who sells credit default swap. In this contract, buyer of CDS needs to pay series of payments called premium to the seller who agrees to reimburse the buyer if there is actually a default.

Credit event results in the settlement if the contract. These events are generally agreed upon by both parties while entering into the contract. Few common creidt events which trigger a payout are bankruptcy, default on payments. Bankruptcy is the event on which the entire contract is based upon. If there is a bankruptcy, then the contract need to upheld by paying the agreed upon protection. Default on payments is when the agreed upon premiums are not satisfied and that will also trigger a termination of the contract.

Till 2008, swaps are not regulated. It means there is no clearing agency to ensure those who sell swaps actually have capital to cover the debt if there is a default. In Mid 2008, there is a more than $40 trillion invested in swaps which is higher than the investments in stock market at that time. Even banks used to buy swaps for complex financial products. Buyers who dont have relationship with the underlying assets also bought swaps without understanding risks. Overnight CDS market fell and gaints like Lehman brothers who had swaps to the extent of 80% of their loans also got hit. Companies like AIG and pacific investments needed a bailout. Small businesses and mortgages has their funding cutoff as everyone understood the risk imposed by the widespread defaults. These factors contributed to unemployment during the crisis.