Wednesday, December 13

Banking Terms–Credit Default Swap

Google+ Pinterest LinkedIn Tumblr +

Banking Terms—Credit Default Swap

Bankers love to use arcane terms that are so much Greek to the rest of us. One we have heard often these days is “credit default swap”. This phrase has appeared in many articles about the meltdown that occurred among big banks starting in 2008. Those who wrote the articles either did not understand the phrase or assumed their readers were too stupid to understand it. Whatever the reason, they did not explain what it means, and covered their tracks by calling it a “complex” concept. I suspect they did not elaborate on what it means because they did not know. It is not really that difficult to grasp. Basically, it is an insurance policy.

Without getting into all the funny phrases bankers like, here is how it works. Company ABC holds a note for money borrowed by company XYZ. This is fine for ABC, as long as XYZ makes the payments. There is a risk involved, though, namely, that XYZ will have a problem and be unable to pay. So ABC decides to buy some insurance from DEF Corporation. In return for regular payments, DEF agrees to assume the risk if XYZ defaults on the note.

This method for spreading risk was originally devised and used by JP Morgan in the 1990s. It has worked very well and created a lot of income for many investment companies. When the economy was booming, risk was spread out all over the place. Apparently, the really brilliant guys that were moving this kind of paper did not discover what might happen if the entity that took out the original loan did not pay—and the party acting as insurer did not have the funds to cover the loss. Lots of different companies bought these so-called “securities” with the intention of reselling them. They knew they did not have the cash on hand to cover the loan if the original party defaulted.

The housing market tanked, foreclosures skyrocketed, and many companies could not cover the loans they had agreed to insure. And the world blew up (economically). Sometimes these instruments changed hands a dozen times; sometimes different companies owned pieces of the same instrument. In some cases it was difficult to disentangle everything and find out which entity was actually liable. 


About Author

Leave A Reply