CDS (Credit Default Swaps) are binding contracts that provide a guarantee against any form of default against corporate debt, mortgage-backed securities and municipal bonds. CDS is a financial swap agreement that the buyer of the swap will be compensated by the seller in case the debtor defaults the loan or any other credit event occurs. The seller receives payments (CDS fee) from the buyer. In case the loan defaults, the buyer of the credit default swap receives a payoff. The compensation received by the buyer is usually equal to the value of the loan. Possession of the loan is then taken by the seller. The credit swap is also known as a credit derivative contract.
Credit default swaps may be partly responsible for major credit crisis. To understand how the swaps may be responsible for credit crisis, it is important to develop a clear visual image of how they are executed. Assume that a company A buys bonds worth one million dollars from company B. After buying the bonds, company A will be exposed to two major forms of risk. The risks will be the default risks and interest rate risks. Company A can choose to use a credit default swap to cushion itself against the default risks associated with buying company B’s shares. If company A is worried about company B’s financial abilities health and thinks that there is a probability that B will default the loan along the way, company A can choose to acquire insurance on the bond by buying a credit default swap. Company A can buy a Credit default swap from a financial institution for example company C. By selling the credit debit transfer to company A, company C has agreed to insure company A’s bonds in exchange for premium payments for a specified period of time. Through the swap, company A has transferred the default risks associated with its buying of company B’s bonds to company C. Should Company B default, company C agrees to make A “whole”. This means that company C will have to compensate A with the difference between the bond's when the credit default swap contract was made and what company A can make from the bond if it chooses to sell the bond. If company B is unable to pay the one million dollars to company B and gives only 100, 000 dollars to company A, company C will have to pay 900, 000 dollars to company A to make A “whole”. If company B is able to pay back the bonds to company A, company A shall collect the money from company B. Company C will not pay a penny and the credit default swap contract shall expire. Company C hopes that this is what will happen. Company A, it will receive payments in the form of premiums for insuring the bonds. In case company C was unable to pay company A, company A may choose to sue company C. After being sued, company C may be forced to declare bankruptcy. If a similar sad scenario replicated on a global scale among corporations and multinational banks and the portfolios of individuals, there would be a debt crisis. Credit default swaps can trigger major credit crisis in economies.
The reason why credit default swaps have triggered major credit crisis is that there are no formal markets where they trade. The size of the CDS market has never been established. The markets thrive in what professionals in the financial market have referred to as the ‘shadow worlds of finance’. In 2008, it was estimated that the CDS market was worth close to 45 trillion dollars. This amount is almost thrice the size of the US economy. It can be assumed that for every bond ever issued by a US entity there is a CDS contract! Because there are no formal markets for the CDS trade, players have been left to set some of the rules and participate in the trade to any degree. This was the case with the AIG insurance company. The company over indulged in the CDS market, an act that cost the taxpayer and the company itself large sums of money. By underwriting CDS, the company used to make a lot of money but in case a large number of bonds the company had written bonds on went belly-up the company was unable to pay.
Under the new structure, the terms of CDS contracts should be standardized to make it easy for a central counterparty to clear them. Lack of a standard playing field has made it easy for scrupulous players to find their way into the CDS market. There should be clear rules that regulate the entry, activities and level of participation of various players in the CDS market. If an institution is judged as an unfit player according to the standard rules, the institution should be barred from participating in the lucrative market. Punitive actions and measures against players who breach the standard rules should be established and implemented accordingly whenever breached.
A consumer protection body that monitors the CDS market should be established. The body will monitor all players in the market and compiling comprehensive profiles about them. The information should then be availed to the public to enable them make informed decisions regarding their participation in the market. The body should expose shoddy deals and ‘shortcuts’ that trigger losses to the responsible authorities. It should also investigate incidents of breach to the laws governing the industry.
The government should also be equipped with the necessary tools needed to manage any financial crisis. The current financial system has clear measures to deal with the collapse of a bank. However, when a financial institution that is not a bank is faced by a financial crisis, only two options are normally available at that juncture: the institution can file for bankruptcy or borrow capital from a willing lender. However, during a financial crisis, an institutional may not acquire the needed capital easily. There are two options available for the institution. It can either file to be declared bankrupt like it happened with the Lehman brothers, or it can obtain funding from the government as in the case of AIG. These two options would cost the taxpayer a lot of money and trigger a credit crisis. In the new structure, an authority that allows the government to fully address the probability of failure of a nonbank financial institution or a bank holding company when financial system stability is at risk should be established.
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