What is a credit default swap (CDS)? Formally, it is defined as a swap which transfers the credit exposure of fixed income products among various parties. Fixed income products are investments that make a return through fixed periodic payments and include such investments as bonds, treasuries, CDs and the ever-dreaded mortgage securities. Banks, hedge funds and other financial institutions engage in the CDS market.
Transfer and reduction of risk is the true concept behind a CDS. The seller of the fixed income product guarantees its credit worthiness to the buyer, who assumes the credit protection. Risk is transferred from the older of the fixed income security to the seller of the CDS.
Ironically, the transfer of risk makes a CDS all the more risky. This unregulated market added to the financial meltdown. According to Janet Morrisey in a March 2008 article for TIME, “The CDS market exploded over the past decade to more than $45 trillion in mid-2007… This is roughly twice the size of the U.S. stock market (which is valued at about $22 trillion and falling) and far exceeds the $7.1 trillion mortgage market and $4.4 trillion U.S. treasuries market.”
Considering how the CDS market could impact the country’s credit crisis, Harvey Miller, senior partner at Weil, Gotshal & Manges, notes, “It could be another — I hate to use the expression — nail in the coffin.”
There were few corporate defaults when times were good. However, as housing prices fell and the credit crisis ensued, firms were no longer able to make goods on their debt. The economy deepened into a recession, and insurers were forced to write down their CDS portfolio. While the CDS market isn’t solely responsible for the current economic crisis, it certainly contributed to its severity.
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