by Josef A

Created on: May 25, 2009

Credit default swaps have attracted the attention of a broader public during the financial crisis. Although they somehow got a reputation of being complex, the basic principle is easily explained and quite straightforward. A credit default swap, as the name says, swaps or transfers the risk of a creditor's default to another party. For the individual or company that wants to get rid of the risk, it is nothing else but an insurance against the default of one of its creditors.

A basic feature of credit default swaps is that they are traded over the counter meaning two parties agree on a non-standard contract and there is no central clearing house as in the option market. Consequently, there are many different variants of those instruments. A common version works as explained in the following. The party interested in insuring its debt buys a credit default swap from a party that is willing to insure against the default of a particular loan or company. A premium is now regularly transferred from the buyer of the CDS to the seller (insurer). This can happen yearly or quarterly or any other period agreed upon. In case the insured company defaults the insurer is obliged to pay out the sum agreed upon in advance, usually the nominal amount of the credit.

The price of a CDS naturally is higher for lower rated creditors. The premium to insure debt of the United States of America is much lower than let's say, Argentina. Therefore, the price of a CDS represents to a certain extent the expectation of the market on how likely the underlying asset is going to default.

As always with derivatives, they can be used for pure speculation by actors who actually do not have lent to anybody. If a speculator believes that a company goes out of business and subsequently defaults on its debt, he can buy a CDS that will rise significantly if his prediction comes true.

The problem with credit default swaps during the financial crisis was that nobody controlled whether the sellers (insurers) actually were solvent enough to fulfill their obligations in case of a default. As a matter of fact, many could not do so and sold credit default swaps, as those instruments generate a steady stream of income. The insurers never expected that they had to step in. The counterparts, those who insured their debts, believed they were not exposed to any kind of risk from the respective loans, what turned out to be fatal for many financial institutions. So indeed, credit default swaps contributed a large share to the complexity and severity of the credit crunch.

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