Homeowners' insurance insures home owners against certain perils, Credit Default Swaps (CDS) are similar dodgy financial instruments launched more than a decade ago. They have exploded so much in the past few years that they are the fastest growing derivatives product currently. The CDS were introduced by major banks in the mid-1990s as an instrument for banks and bondholders to buy `insurance' when companies failed to pay their debts. Investors raised money by taking long or short positions in the securities of particular companies without having to buy or sell the actual underlying bank debt or securities. The market for these derivatives has been astonishing and the notional value grew to a mind-boggling amount of $62.2 tn by December 2007 up from some $34.4 tn in 2006. In contrast, issuance of Collateralized Debt Obligations (CDOs) plunged dramatically. Industry estimates show it was a paltry $11.7 bn in the first quarter, down from a record $186.5 bn in the same period the year before.
In case of stock futures, and options markets, the market prices of securities and contracts are widely available. Alternatively, CDS trade on a decentralized `over-the-counter market' and prices vary from firm to firm. Barclays Capital recently estimated that failure of a major counter-party could lead to losses of $36 bn to $47 bn across the financial system. With the global financial system unsettled and the subprime credit crunch expanding, it is proven that many investors have done a very poor job of properly gauging their exposure. The big story for this year could be the disaster of these CDS. Even with the default of a mere 10% of the current $45 tn of CDS, the potential ramifications are difficult to overstate. This is big news now as many other banks, funds, and insurers are similarly exposed. It is also a concern to the CDS purchasers, who think the value of their assets hedged against defaults. However, they may find this protection worthless if the counter-part is unable to pay. |
