Credit default swaps

Definition

Credit default swaps (CDS) are financial derivatives that allow an investor to 'swap' or transfer the credit risk of fixed income products between parties. Essentially, they act as insurance against the default of a borrower, where the buyer pays periodic premiums to the seller in exchange for a payoff if the underlying asset defaults. This mechanism became particularly significant during the financial crisis, as it allowed for the creation of complex financial products that obscured the true risk associated with mortgage-backed securities.

5 Must Know Facts For Your Next Test

1. Credit default swaps gained popularity in the early 2000s as investors sought ways to hedge against potential losses from mortgage-backed securities.
2. The use of CDS contributed to the financial crisis by allowing institutions to take on excessive risk without fully understanding their exposure to defaults.
3. AIG, a major insurer, faced significant losses due to its exposure to credit default swaps linked to subprime mortgages, requiring a government bailout.
4. The lack of regulation surrounding credit default swaps allowed them to be traded over-the-counter, making it difficult to assess the overall risk in the financial system.
5. In the aftermath of the crisis, reforms were implemented to increase transparency and reduce systemic risk associated with credit default swaps.

Review Questions

• How do credit default swaps function as financial instruments and what role did they play in the financial crisis?
  • Credit default swaps function by allowing investors to transfer the credit risk associated with debt instruments. Investors pay premiums to CDS sellers for protection against borrower defaults. During the financial crisis, these instruments magnified risks as they were used extensively in conjunction with mortgage-backed securities. This led to widespread defaults that not only affected individual investors but also resulted in systemic failures among major financial institutions.
• Evaluate the impact of unregulated credit default swaps on financial markets leading up to the crisis.
  • Unregulated credit default swaps created a lack of transparency in financial markets, making it challenging for investors and regulators to gauge the true level of risk within institutions. The complexity of these derivatives allowed banks and investment firms to take on more risk than they could handle. As defaults increased, many entities found themselves unable to cover their obligations under CDS contracts, contributing significantly to the liquidity crisis and exacerbating the downturn.
• Discuss how reforms following the financial crisis have altered the trading and regulation of credit default swaps and their implications for future market stability.
  • In response to the financial crisis, reforms such as mandatory clearing through central counterparties and increased reporting requirements for credit default swaps were implemented. These changes aim to enhance transparency and reduce systemic risks by ensuring that all trades are recorded and monitored. Additionally, regulators now focus on limiting excessive leverage and ensuring that institutions have adequate capital reserves. Such reforms are designed to prevent a repeat of the catastrophic failures seen during the crisis and contribute to greater overall stability in financial markets.

Related terms

mortgage-backed securities:

Investment products made up of a bundle of home loans that are sold as a single security, often used to finance real estate purchases.

subprime mortgages:

Loans given to borrowers with lower credit ratings who are considered higher risk, contributing to increased defaults during the housing crisis.

collateralized debt obligations: Structured financial products backed by a pool of loans and other assets, often used in conjunction with credit default swaps to spread risk.