Credit-default swaps

What are Credit-default swaps?

The current European financial crisis is once again bringing credit default swaps to the public’s attention. But what are they? What do they do?

A credit-default swap (CDS) is a form of insurance policy that anyone can take out on any type of loan product such as government bonds and home mortgages, whether or not they have a connection to it.

Creating a CDS involves a risk assessment process using formulae which can be quite complex with some types of loans. The holder of the CDS will then pay a premium, usually every quarter.

As CDSs are developed from and their value is dependant on basic financial instruments, such as loans, they are known as derivatives.

How large is the CDS market?

A breakdown of the type of derivatives held by US banks in 2008 shows that CDS accounted for just under 10% of the total.

The largest market for CDSs are actually corporate bonds, this market is around eight times larger than that for government (sovereign) bonds.

As an aside, although it’s difficult to be certain, the total size of the derivatives market by 2009 was estimated to be worth somewhere around $1 quadrillion. To put that into context, global GDP in 2009 was $58.26 Trillion.

Influence of the CDS market on sovereign debt

It is in relation to sovereign debt that CDSs most often hit the news, but how much influence and what is the nature of their influence over sovereign debt?

The proportion of CDSs of most countries debt is surprisingly small given their publicity. For the current crisis in Greece, sovereign debt stands at just under $500 billion of which CDSs provide cover for about $5 billion, around 1%.

Where CDSs exert their greatest influence is when it comes to obtaining loans. Issuers will normally only grant loans that they can insure or afford to insure. In this respect CDSs are a barometer of risk, the higher the risk the harsher the terms of the loan, if it’s granted at all.

This presents a twin problem for countries such as Greece, Ireland and Portugal carrying large amounts of debt. Servicing existing loans becomes more difficult because of the increased cost of new loans. In addition to this, with an absence of real economic growth to increase revenues, a positive feedback condition can occur that accelerates a country to a debt default.

Moral Hazard

A more malign influence can come into play from those taking out CDSs if they have no vested interest in the original loan or stand to gain more financially if a loan is defaulted on. They may be tempted into actions that deliberately bring about failure. This is commonly referred to as moral hazard. This issue attracted a lot of attention during the financial crash. So much so that Germany legislated against ‘naked short selling‘. It is arguable how much damage this sort of activity does and is probably more analogous to deterring vultures circling a kill rather than preventing the kill in the first place

The reality is that there are limits to the power of the CDS market beyond the pricing of risk. While not a particularly socially useful activity, on balance CDSs probably do far less damage than commodity speculation.

Gary Hollands – November 2nd 2011.

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