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Credit Default Swaps (Explained)

Yet another financial term in the news these past few months.
A couple weeks ago, MSN money printed an article “10 companies that could go bankrupt” in which they disclose that the criteria to be chosen for the list was the value of the credit default swaps on the companies’ 5 year bonds.

So let’s look a bit at what this means. When an institutional buyer of say $1M face value in a company’s bonds want to protect itself from the risk the company will default, it may enter into an agreement with a third party and pay an annual premium similar to an insurance policy. If the company pays 8% (or $80,000 on that million face value), the buyer may pay $20,000 to the third party for insurance against default, otherwise known as a credit default swap (CDS). Simple enough, right? Well, not so fast. One may buy the CDS without having the bond it’s insuring against. Consider this – An insurance company will not sell a life insurance policy on me to a stranger. Nor will it sell me an inappropriate amount of insurance, say 100 times my annual income. (Imagine the macabre possibilities if a stranger could buy any size policy on your life, the making of a horror film.) No such regulations apply to CDSs. So there’s a fine line between a CDS functioning as proper hedge against risk and one which is part of a speculation running counter to the good of the system.

As the subprime market started to fail many bonds dropped in value causing distortions in the CDSs traded on those bonds. Many of the companies on the MSN list have positive cash flow, servicing their debt, and buying it back at depressed prices. Will some of them fail? No doubt. The article itself was based in poor research which was not adequately described for the reader’s benefit. The equivalent of throwing gas on a fire.

Joe

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