Credit Default Swap

I am sure you have all heard about these credit products, so now I will explain them in lay terms. Credit Default Swap (CDS) contracts have been compared to insurance, because the buyer pays a premium, and in return receives a sum of money if a specified event occurs. However, this is a slightly misleading comparison because the buyer of a CDS does not need to own the underlying security; in fact the buyer does not even have to suffer a loss from the default event.

Basically one company agrees to insure the assets of another company at the insured party pays the insuring party a yearly fee or premium. Lets say an asset management (Company A)firm owned a $10m Lehman Brother bonds and that that bond carried a A+ rating. Now a smaller firm (Company B)agrees to insure that bond in case of default at a rate of 5% per year for a period of two years.
If the Lehman bond went into default after one year, Company A would have paid Company B $500,000, however Company B would owe Company A the balance of the insured bond or $10,000,000.

Critics of the huge credit default swap market have claimed that it has been allowed to become too large without proper regulation, and that because all contracts are privately negotiated, that the market has no transparency. Furthmore there have even been claims that CDS's exacerbated the 2008 global financial crisis by hastening the demise of companies such as Lehman Brothers and AIG.

In the case of Lehman Brothers it is claimed that the widening of the bank's CDS spread reduced confidence in the bank and ultimately gave it further problems that it was not able to overcome. However, proponents of the CDS market argue that this confuses cause and effect; CDS spreads simply reflected the reality, that the company was in serious trouble. Furthermore they claim that the CDS market allowed investors who had counterparty risk with Lehman Brothers to reduce their exposure in the case of their default.


This works except when the bond defaults and company B only have $5,000,000 and therefore can not afford to pay Company A what it is owed. No we have a loose-loose situation and neither party is made whole.

All of this came during the Asian financial crisis of 1997. Some very smart bankers at JP Morgan Chase decided that they needed to "hedge" against double losses.