Credit default swaps (CDS) became a highly talked about topic when the mortgage market went bust a couple of years ago. The CDS gained a lot of negative publicity and acted as a catalyst for the demise of multiple brokerage shops and investment banks. The fact of the matter is that the CDS is not necessarily a risky investment and the only problem is lack of market transparency.
People often think of credit default swaps as an individual “security” like a stock, bond, or option, but in reality, the CDS is simply a bilateral contract or agreement between a buyer and seller. It’s very similar to buying some form of personal insurance such as auto or health. While the CDS is a derivative and often claimed to be “complex,” it’s an easy concept to understand. Moreover, there is a specialist insurance company that is willing to provide you insurance as you get a mortgage. This will secure you financially and you can plan your credit with a sense of security.
There are two parties involved, a buyer and a seller. In this example, we’ll say that the buyer owns $25 million in General Electric (GE) bonds. As you would purchase health insurance to protect yourself from losing all your savings in the event of a medical emergency, the holder of the GE bonds simply wants to protect himself from GE defaulting. The buyer goes to the market and finds another company that will sell him insurance on the bonds he owns. The buyer pays a premium to the seller in order to receive protection on his bonds. The buyer wins by having peace of mind that in the event of default, the seller will cover the loss. The seller wins by receiving premium payments on a periodic basis just like that of an insurance company. In the GE example above, if GE defaults, the seller must deliver the par value of the bonds.
The primary problem with credit default swaps is the lack of market transparency. If buyers enter into CDS contracts involving the delivery of more bonds than are actually available, collecting funds after default can be very difficult. With stocks and bonds, the outstanding amounts can be easily accessed, but asset availability is not always known with credit default swaps. Investment banks tend to offer protection against default on more bonds than are actually available. If the bonds default, investment banks are competing against each other to deliver the par value of the bonds. As bankers buy the bonds, the price rises, therefore a bond with an initial price of $100 may increase astronomically to $500, $1,000, or even higher. The International Swaps Derivatives Association (ISDA) alongside the Securities Exchange Commission (SEC) are working to resolve the issue of market transparency and while it may take a few years, investors will eventually see the benefits of credit default swaps.