Tuesday, May 15, 2012

(Opinion) Credit Default Swaps: The Sellers Nightmare, the buyer's dream

There are plenty of products out there that are a risky sell, that may be volatile and thus difficult to shift but there is one product that stands alone in risk and volatility: the Credit Default Swap(CDS). Credit default swaps are basically an insurance policy against default of a number of products but are mostly used for loans and bonds.

While on the surface there is nothing wrong with this sort of transaction, it suffers from one fatal flaw: the buyers of credit default swaps benefits heavily if the loans and bonds bought goes sour. This was the main cause of the financial crisis of 2007-2009 as savvy investors bought credit default swaps on loans with horrible interest rates given to people who had no means at disposal to pay for the loan, meaning defaults would happen on large scale and investors cashed in.

This was made worse as rating agencies gave triple A status to loans that were either of poor quality (little or no financial provisions on borrowers + nosebleed interest rates after 'teaser' or introductory offers have expired) or grouped together as CDO's or Collateralized Debt Obligations.

Companies such as Goldamn Sachs cashed in as they bought CDS against their own products.It seems obvious that it might be a bad idea to insure something when it's chances for default or destruction can be predicted or the quality, or lack of which, can be concealed but this wasn't apparent to the fine people at AIG, who ended up holding one of the largest bags in financial history.

CDS are an evolution in investing as a investor can hedge his bets without having to go through the complicated process of shorting their positions. In effect, credit default swaps are a straight gamble as the investor wagers on the fate of a given loan or bond with the insurer acting as a bookmaker, but the odds seems heavily in favour of the buyer savvy enough to realise the true volatility of product insured.Some may see this as a dishonest way to make a living, however, if the loans and bonds offered to borrowers and investors were of greater quality, there would not be a 30 trillion market in credit default swaps

In sum, credit default swaps maybe the quickest way to bankruptcy for big insurers but they are the best thing to happen to the investor as he can make a straight bet if he thinks a product is of poor quality and in the long run may force creditors and rating agencies to up their standards to avoid the financial debacle of 2007-2009.  

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