Credit default swaps (CDS) are financial derivatives that insure against bond risks. They allow the lender to transfer their risks to another party.
How Credit Default Swaps Work
Here’s an example to illustrate how swaps work. Let’s assume a company issues a bond. Several companies buy the bond, thereby lending the company money. They want to ensure they won’t incur losses if the borrower defaults, so they purchase a credit default swap from a third party.
Advantages of Credit Default Swaps
Swaps protect lenders from credit risks. This allows bond buyers to finance riskier projects than they would have without them. Investments in risky projects boost innovation and creativity, enhancing economic growth. This is how Silicon Valley became a center of innovation in America.
Disadvantages of Credit Default Swaps
On the other hand, swaps were largely unregulated until 2010. This meant there was no government agency ensuring that the swap seller had enough money to pay the owner if the bond defaulted. In fact, most of the financial institutions selling swaps weren’t capitalized adequately. They only kept a small percentage of what they needed to cover the insurance. The system worked until borrowers began to default.
How Swaps Caused the 2008 Crisis
By mid-2007, over $45 trillion was invested in swaps. This was more than the money invested in U.S. stocks, mortgages, and U.S. bonds combined. The U.S. stock market held $22 trillion. Mortgages were valued at $7.1 trillion, and U.S. bonds were valued at $4.4 trillion.
Dodd-Frank Reforms
In 2010, the Dodd-Frank Wall Street Reform Act regulated credit default swaps in three ways: The Volcker Rule prevents banks from using customer deposits to invest in derivatives, including swaps. It requires the Commodity Futures Trading Commission to regulate swaps, including the creation of a clearinghouse for trading and pricing. It removes the riskiest credit default swaps.
JP Morgan Chase Loss
On May 10, 2012, JP Morgan Chase CEO Jamie Dimon announced that the bank lost $2 billion due to credit default swaps. By December 31, 2012, the trade had cost $6.2 billion. The bank’s London office executed a series of complex trades that would be profitable if corporate bond indices rose. One of these trades was a portfolio of credit default swaps. When the trade started losing money, many other traders took the opposite position. They hoped to profit from JP Morgan’s losses, exacerbating the loss.
Greek Debt Crisis and Credit Default Swaps
The false sense of security provided by credit default swaps also contributed to the Greek debt crisis. Investors bought Greek sovereign debt, even though the country’s debt-to-GDP ratio exceeded the EU’s allowable limit of 60%. They also bought credit default swaps to protect themselves from the possibility of default.
In 2012, these investors discovered how little the credit default swaps actually protected them. Greece required bondholders to take a loss on their holdings. The credit default swaps did not protect them from this loss. This incident should have devastated the credit default swap market. However, it set a precedent that borrowers, like Greece, could deliberately bypass credit default swap payments. The International Swaps and Derivatives Association decided that credit default swaps would be paid regardless.
Source: https://www.thebalancemoney.com/credit-default-swaps-pros-cons-crises-examples-3305920
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