Notes On Credit Default Swaps

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Credit Default Swaps Another financial vehicle that could be problematic was CDS (credit default swap). CDS is a financial derivative works like insurance on securities. The underwriter is obligated to pay a pre-determined fee to counterparty if a certain security default. In return, underwriters charge a fee as compensation. CDS can be used to hedge against risks. However there are still some difference between a CDS and an insurance contract. The CDS does not require buyers to actually hold underlying assets. That means a third party can “insure” against default risk that it would not bear the consequence at the first place. A financial institution can act like an insurance company by selling CDSs. American International Group (AIG) was the largest CDS underwriter during the crisis. AIG issued tons of CDSs because historical default rate on bonds were so low that issuing CDS became a cash generator. They simply collected the premium and never though of paying out anything until the crisis hit. Another thing that CDS is different from the insurance is that an insurance pool can be much better diversified. For example, a car crash in Los Angeles will not increase the risk of another car crash in New York since two events of car crash are not correlated to each other. However, as mentioned before, when the house price bubble popped, the events of defaulting on mortgage can have high correlations. When millions of mortgages defaulted one after another, the institutes had
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