14/01: Credit Default Swaps
Talk in the financial media about the growing CDS (credit default swaps) problem has just begun.
This may be new to you but it is a growing story and a huge risk that is not well understood.
A CDS is a contract between the holder of a risky asset (say a portfolio of sub-prime loans, credit cards, etc) and a financial entity willing to guaranteee that risky asset against default. Very similar to insurance policies except that there is no regulation and unless the protection buyer has done her homework there may not be adequate collateral to insure the risk.
A Wall Street Investment bank builds a portfolio of sub-prime debt and then buys this insurance from a hedge fund through the issuance of a derivative contract - a CDS. The protection buyer (Wall Street Bank) pays a monthly premium to the Protection Seller (hedge fund) and all is well until a default occurs (much more common now than two years ago). In default, the protection buyer excercises her claim and the protection seller is forced to ante up the loss. The hedge fund or [protection seller is called the counter party. And therein lies the problem.
If the hedge fund or other counter-party is unable to meet its obligation when a default occurs it creates a significant problem in the financial system. This situation is the current risk we face. Some have estimated that there are 3 CDS contracts written for every package of sub-prime loans! The CDS default problem may dwarf what we have already seen. Stay tuned.
OSF
January 14, 2007
This may be new to you but it is a growing story and a huge risk that is not well understood.
A CDS is a contract between the holder of a risky asset (say a portfolio of sub-prime loans, credit cards, etc) and a financial entity willing to guaranteee that risky asset against default. Very similar to insurance policies except that there is no regulation and unless the protection buyer has done her homework there may not be adequate collateral to insure the risk.
A Wall Street Investment bank builds a portfolio of sub-prime debt and then buys this insurance from a hedge fund through the issuance of a derivative contract - a CDS. The protection buyer (Wall Street Bank) pays a monthly premium to the Protection Seller (hedge fund) and all is well until a default occurs (much more common now than two years ago). In default, the protection buyer excercises her claim and the protection seller is forced to ante up the loss. The hedge fund or [protection seller is called the counter party. And therein lies the problem.
If the hedge fund or other counter-party is unable to meet its obligation when a default occurs it creates a significant problem in the financial system. This situation is the current risk we face. Some have estimated that there are 3 CDS contracts written for every package of sub-prime loans! The CDS default problem may dwarf what we have already seen. Stay tuned.
OSF
January 14, 2007
