Credit Default Swaps and Financial WMDs

Monday, February 18, 2008 | 07:34 AM

Gretchen Morgenson's NYT article yesterday offered a good primer about Credit Default Swaps (CDS):

Few Americans have heard of credit default swaps, arcane financial instruments invented by Wall Street about a decade ago. But if the economy keeps slowing, credit default swaps, like subprime mortgages, may become a household term.

Credit default swaps form a large but obscure market that will be put to its first big test as a looming economic downturn strains companies’ finances. Like a homeowner’s policy that insures against a flood or fire, these instruments are intended to cover losses to banks and bondholders when companies fail to pay their debts.

As the graphics explain, counter-party risk is an ever present factor.

click for larger graphics

graphic courtesy of NYT

What's truly astonishing is the size of this market: The market for these securities is enormous. Since 2000, it has ballooned from $900 billion to more than $45.5 trillion — bigger than the US equity markets, US Treasuries, and Mortgage Securities -- COMBINED.

click for larger graphics


graphic courtesy of NYT

CDS are thinly traded, have huge counter-party risk, are difficult to analyze, and are unreguylated insurance products. This leadsme to this money quote:

"As with other securities that trade privately and by appointment, assigning values to credit default swaps is highly subjective. So some on Wall Street wonder how much of the paper gains generated in these instruments by firms and hedge funds last year will turn out to be illusory when they try to cash them in."

Sounds kinda familiar . . .


Arcane Market Is Next to Face Big Credit Test
NYT, February 17, 2008

Monday, February 18, 2008 | 07:34 AM | Permalink | Comments (55) | TrackBack (1) add to | digg digg this! | technorati add to technorati | email email this post



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Tracked on Feb 18, 2008 9:03:37 AM


Credit default swap is analogous to Captive insurance. Both are mostly unregulated and under capitalized. Hey Vermont lawyers, are ya covered?

Posted by: AGG | Feb 18, 2008 7:56:56 AM

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