There really isn’t much discussion in newspapers or on the news about CDS or Credit Default Swaps. CDS’s are one reason that some of the larger insurance companies are having the troubles that they are. Many financial experts feel that the issue of CDS’s is only going to become worse, but the media seems really isn’t talking about this situation at all.
The problem we are currently facing is due to financing schemes that have been created in the last few years. When people speak of “leverage” they often really mean derivatives. It is these new forms of derivatives and securities that are backed by mortgages that are at the crux of the problem. Declining home values are not the cause of the current financial crisis. They are a symptom of the disease that has been helped along by exotic derivatives.
At $62 trillion, the CDS derivative market is enormous, and not many outside of the financial industry are actually aware of it.
What is a CDS?
If a corporate bond gets wiped out due to the failure of a corporation, CDSs are insurance that cover the bonds.
Normally a person can’t buy insurance on something that they don’t own. But with CDSs speculation is an option. People can buy insurance on corporate bonds, even if they don’t own the bonds. The reality of this is that people who hold the insurance benefit if the corporation goes under. Even worse, there are hedge funds that have been known to purposefully attempt to devalue stocks in an attempt to induce bankruptcy. These attempts at stock devaluation are being done while taking part in CDS speculation.
What’s wrong with CDS?
Unlike stocks, there really are no regulations governing the buying and selling of CDS. Like stocks, CDSs can be traded, sold, or bought. Can you imagine no regulation? There has been a void where you would normally find regulation in financial markets. This lack of an overseeing agency has enabled the insuring of corporate bonds beyond the limits that can be covered in the event of a financial melt down.
Countdown to disaster
Dominoes anyone? If a company has to declare bankruptcy due to writing CDS contracts that they can’t cover due to the billions of dollars they would have to come up with, what happens to the companies that are covering them? Well, they too don’t have the money to cover the insurance so they fail too. What about the companies that were covering those companies? Bingo! The companies that were covering them also fail, and so on.
Large companies can fail, and do fail. It happens. Insurance companies never would have imagined such a large company like Lehman could go under, but nothing is impossible. Because they held this belief they continued to write CDS contracts that would never hold up if a large institution went under.
Now you have the government getting involved, but is it a little too little a little too late? We’ll have to wait and see.