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A credit default swap (CDS) is the most highly utilized type of credit derivative. In its most basic terms, a credit default swap is similar to an insurance contract, providing the buyer with protection against specific risks. Most often, corporate bond investors buy credit default swaps for protection against a default by the issuer of the corporate bond, but these flexible instruments can be used in many ways to customize exposure to corporate credit.
CDS contracts can mitigate risks in bond investing by transferring a given risk from one party to another without transferring the underlying bond or other credit asset. Prior to credit default swaps, there was no vehicle to transfer the risk of a default or other credit event, such as a downgrade, from one investor to another.
In a CDS, one party "sells" risk and the counterparty "buys" that risk. The "seller" of credit risk-who also tends to own the underlying credit asset-pays a periodic fee to the risk "buyer." In return, the risk "buyer" agrees to pay the "seller" a set amount if there is a default (technically, a credit event). CDS are designed to cover many risks, including: defaults, bankruptcies and credit rating downgrades (For a more detailed list of CDS credit events see the Commonly Established CDS Credit Events table below).
The following graphic illustrates the credit default swap transaction between the risk "seller," who is also the protection "buyer," and the risk "buyer," who is also the protection "seller."
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The credit default swap market is generally divided into three sectors: corporates, bank credits and emerging market sovereigns. CDS can reference a single credit or multiple credits. Multi-credit CDS can reference a custom portfolio of credits agreed upon by the buyer and seller, or a CDS index. The credits referenced in a CDS are known as "reference entities." CDS range in maturity from one to 10 years although the five-year CDS is the most frequently traded.
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Many on Wall Street and the rest of us are still digesting the momentous events of the last 10 days. Between one and three trillion dollars worth of financial assets have evaporated. Wall Street has been effectively nationalized. The Federal Reserve and the Treasury Department are making all the major strategic decisions in the financial sector and, with the rescue of the American International Group (AIG), the U.S. government now runs the world's biggest insurance company. At $700 billion, the biggest bailout since the Great Depression is being desperately cobbled together to save the global financial system.
OpenMarket.org » Archive » Paulson bailout would worsen ...
... Secretary Henry Paulson’s $700 billion bailout — stopping the “contagion” of securitized loans that have become illiquid — could be achieved if mark-to-market accounting ...
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The Bailout Alternative: Virtual Mark to Market « blog maverick
According to some pundits, the simplest solution to our economic crisis is to suspend or abolish the mark to market accounting rules. For those unfamiliar.
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OpenMarket.org » accounting
... Secretary Henry Paulson’s $700 billion bailout — stopping the “contagion” of securitized loans that have become illiquid — could be achieved if mark-to-market accounting ...
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Wonk Room » Why Newt Gingrich Is Wrong About Mark-To-Market ...
Why Newt Gingrich Is Wrong About Mark-To-Market Accounting » Calling the Bush-Paulson bailout proposal a “ dead loser ” and a “ very, very bad idea,” Newt Gingrich is ...
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Bernanke: Bailout Would Cool Fire Sales - Accounting - CFO.com
Although many banks support a temporary halt to mark-to-market accounting, 'doing this would only hurt investor confidence,' the Fed chairman says.
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As the market goes, so goes the electorate
People had never heard of mark-to-market accounting, all of a sudden this is a household word," said Representative Michele Bachmann, Republican of Minnesota, who voted against the bailout and said most of her constituents were calling to say she did ...
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Source: International Herald Tribune
NewsDateTime: 6 hours ago
In bailout, still room for doubt
So giving the SEC permission to suspend mark-to-market accounting leaves a bad taste. And by ushering the bill alongside tax ... cash while they can - especially if something happens to alarm them, like the initial failure of the U.S. bailout ...
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Source: International Herald Tribune
NewsDateTime: 53 minutes ago
Senate Passes Bailout 74-25
The bailout will insure that a depression will not occur that is the real intention. Pass the bailout and avoid the ... Alright the mark to market accounting rule made the banks take sub-prime write downs by realizing losses on loans today NOT as these ...
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Source: BusinessWeek
NewsDateTime: 46 minutes ago
Senate gives new life to bailout; Levin, Stabenow split votes
As in the debate before the House defeated the bailout Monday, backers in the Senate warned the rescue was ... Some House Republicans had pushed to temporarily repeal such mark-to-market rules entirely, but accounting firms and some consumer groups said ...
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Source: Detroit Free Press
NewsDateTime: 2 hours ago
Suspend Mark-To-Market Now!
... regulators fail to use their discretion--can fix 70% of the financial crisis by changing the mark-to-market accounting rule, we should change the rule first before attempting to pass another reevaluated bailout package. "Mark-to-Market" Accounting ...
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Source: Forbes
NewsDateTime: 9/29/2008
Characteristics of Credit Default Swaps
Unlike total return swaps that provide protection against the loss of credit value irrespective of the cause, credit default swaps provide protection only against previously agreed upon credit events. Below are the most common credit events that trigger a payment from the risk "buyer" to the risk "seller" in a CDS.
The settlement terms of a CDS are determined when the CDS contract is written. The most common type of CDS involves exchanging bonds for their par value, although the settlement can also be in the form of a cash payment equal to the difference between the bonds’ market value and par value.
How Has the Credit Default Swaps Market Evolved?
The CDS market was originally formed to provide banks with the means to transfer credit exposure and free up regulatory capital. As the credit default swaps market became more standardized and gained credibility, particularly following smooth credit event settlements in high profile cases such as WorldCom and Enron, more investors entered the market. While banks-through broker-dealers and reinsurance companies-are still both the largest buyers and sellers of credit default swaps, investment management firms are following closely.
Today, CDS have become the engine that drives the credit derivatives market. According to the British Bankers’ Association, the credit default swaps market currently represents over one-half of the global credit derivative market. The growth of the CDS market is due largely to CDS’ flexibility as an active portfolio management tool with the ability to customize exposure to corporate credit. In addition to hedging event risk, the potential benefits of CDS include:
A short positioning vehicle that does not require an initial cash outlay
Access to maturity exposures not available in the cash market
Access to credit risk not available in the cash market due to a limited supply of the underlying bonds
Investments in foreign credits without currency risk
The ability to effectively ‘exit’ credit positions in periods of low liquidity
The performance of credit default swaps, like that of corporate bonds, is closely related to changes in credit spreads. This sensitivity makes them an effective hedging tool that can assume exposure to changes in credit spreads as well as default risk. Credit default swaps also have given rise to new arbitrage opportunities, particularly in global markets that do not have the transparency or efficiency of the U.S. credit markets.
Conclusion
The event risk embedded in bonds and other credit assets was very difficult to reduce prior to the evolution of credit default swaps. In the brief decade since their inception, credit default swaps have become not only a tool that effectively hedges event risk but also a flexible portfolio management tool that far exceeds that single benefit.
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