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- About Home Equity Loans In Texas And How Can One Obtain It - November 27, 2023
About Credit Default Swap (CDS)
Loans and credit products are the ways for lenders and banks to make profits. However, when a lender or a bank is providing a loan or credit to any borrower they are always at the risk of the borrower defaulting on the loan.
Hence many banks, lenders, and financial institutions use something called a credit default swap or CDS. In this post, we will understand what is CDS and how it works in detail.
What Is A Credit Default Swap?
CDS is a type of financial credit derivative that helps the bank, lender, or financial institution to protect against possible default on loans or credits and other risks.
The CDS buyer makes periodic installments to the seller up to the expiration date of the credit or the loan.
In this, the seller agrees to pay the buyer with all the installments with interest for the debt if the borrower defaults on the loan or the credit issued.
How Does The Credit Default Swap Work?
With the help of a credit swap, the buyer can make regular installments to the insurance company and transfer the risk of default to the insurance company or another investor in case the debt is not paid.
Similar to an insurance policy, a CDS allows buyers to purchase protection against unfortunate events that could affect their investments.
For example: Suppose an investor buys a 30-year bond for $20,000. Long maturities add uncertainty to investors, as the company may not be able to pay the $20,000 principal or future interest before maturity.
To guarantee the likelihood of these outcomes, the investor will purchase a CDS.
A credit default swap guarantees payment of principal or interest over a predetermined period. Investors typically purchase credit default swaps from large financial institutions that guarantee their underlying debt for a fee.
What Is The History Behind Credit Default Swap?
CDS was introduced by JP Morgan’s Blythe Masters in 1994 which gained a lot of limelight in the early 2000s.
By the year 2007, the value of CDS was estimated at around $62 trillion which was more than the combined value of mortgages, U.S Treasuries, and the stock market.
The biggest concern for investors with CDS was that there was no regulatory body to manage them.
In the 2008 crisis, the CDS could not cover the amount of default due to which the Federal Reserve Of the United States had to intervene to resolve the issue.
In 2009, The Dodd-Frank Wall Street Report Act was introduced to regulate the CDS market.
This Act phased out the riskiest credit swaps and also disallowed the banks and financial institutions from utilizing customer deposits to invest in credit swaps and other derivatives.
What Is The Uses Of Credit Default Swap?
There are two key reasons why credit swaps are used: hedging and speculative risk. In hedging risk, investors purchase CDS to add one more layer of insurance to prevent defaults on bonds such as mortgage-backed securities.
The risk of default is transferred to a third party like an insurance company or other investors who receive premiums to secure these bonds.
Conversely, when investors speculate on credit default swaps, they are taking a chance on the credit quality of the reference entity.
Conclusion
CDS was a key factor in the 2008 financial crisis. During that period, investment banks purchased CDS against high-risk loans that they issued to the borrowers.
The rate of default was so high that CDS was not able to cover the total amount and the U.S. Federal Reserve had to step in to bail it out.
Now since there is a regulatory body keeping an eye on the CDS market, we hope that this market stays stable and avoids any issues in the future.
