subject: Credit Risk Management and therefore the Money Crisis - Are Credit Default Swaps to Blame? [print this page] Credit Risk Management and therefore the Money Crisis - Are Credit Default Swaps to Blame?
Credit default swaps (CDS) are widely blamed by politicians, regulators and also the media for his or her role in the continuing crisis. What was their original purpose, and the way have they contributed to the turmoil within the economy? A credit default swap could be a credit derivative; this can be a financial instrument whose worth depends on an underlying or reference asset, such as a bond, bank loan, mortgage, etc. Credit derivatives enable monetary establishments to hedge the risk of losses to their portfolios because of events like bankruptcy or ratings downgrades. Credit default swaps were introduced by Wall Street within the mid-1990s as a kind of insurance against credit risk. A CDS is an agreement between a protection buyer and a protection seller in that the customer makes a regular series of payments in exchange for a settlement within the event of a credit loss by a reference asset. Because of their flexibility, the recognition of credit default swaps grew rapidly, giving rise to a lot of complex variations. One of those is that the credit default swap index, in which the reference asset is the common worth of a collection of bonds; these bonds can be chosen from a selected sector of the economy, ratings category or country. This product permits hedgers to shop for protection from a broad vary of assets at a comparatively low cost. STRUCTURED PRODUCTS The explosive growth of the CDS market, whose size reached an estimated $60 trillion by 2007, impressed Wall Street to provide progressively additional refined credit derivatives. The foremost complicated of those are referred to as structured credit products. These are created when a monetary institution acquires a pool of risky assets and distributes the promised money flows to investors through a series of categories or tranches. The tranches are segregated by credit risk, with the riskiest tranches offering the very best potential rate of return. This kind of structure will increase the alternatives accessible to investors, who will simply customize their exposure to credit risk. One in every of the foremost necessary structured credit product is that the Collateralized Debt Obligation (CDO). A CDO is sometimes backed by extraordinarily risky assets, such as sub-prime mortgages, low-rated corporate bonds, even tranches of alternative CDOs. So as to extend the attractiveness of a CDO, the issuer might sell protection to investors through a CDS. WHAT WENT WRONG? Notwithstanding the various benefits associated with credit default swaps and other credit derivatives, they're extraordinarily risky products, both for patrons and sellers. Warren Buffet famously compared by-product securities to weapons of mass destruction, because of their potential for catastrophic losses. In the push to earn profits, several money establishments overlooked the chance stemming from their positions in credit derivatives. In particular, the CDS market enabled corporations to take huge speculative positions on credit risk, since there aren't any legal needs for defense sellers to possess the reference asset or hold capital as a cushion against potential losses. The tipping purpose came when the number of defaults among sub-prime mortgages began to surge, triggering sizable credit losses, particularly among leveraged products like CDOs. The lack of protection sellers to cover their losses any magnified the crisis; several investors who believed that they were insured against credit losses saw the price of their holdings plunge. The crisis saw the disappearance of Bear Stearns, Lehman Brothers and Merrill Lynch, whereas bond insurer AIG required a large government bailout to survive. The fallout of the crisis has led to demand reform of the credit derivatives markets; some proposals have included the creation of a clearinghouse, that would reduce counter-party risk and increase the transparency of the market. No matter the reforms that are enacted, CDS and other credit derivatives can still be used by money institutions as half of an overall risk management strategy. There can be less use of CDS as speculative instruments, as market participants have hopefully learned that CDS can be powerful tools when used correctly, however will wreak havoc when used for gambling purposes.
