Can anyone explain me what is a Credit Default Swap? And what are the merits and demerits of it?
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It’s a bet. If I sell you a CDS I am taking your money because I like money. I promise you that is some specific loan defaults (the borrower doesn’t make the payments), I will pay you back. I’m betting they won’t default.
Like all bets, it’s relatively fair and useful if defaults are random. The lender is sharing the risk with CDS sellers, and like all insurance the CDS sellers get to make a little profit for this risk reduction.
The 2008 Economic Collapse was caused by CDS use. It turns out that home loan defaults are not random. An economic downturn can cause a spike in them because everybody needs the economy to do well to keep their job so they can pay their mortgage.
They act like insurance on a loan. You pay a small premium, and if loan defaults you get paid. If you are a lender, it’s a way to reduce risk.
However, they became risky in the overall financial markets because one doesn’t need to own the underlying debt to buy a credit default swap on it. It’s be like you taking out a policy where you get paid out insurance claim, too, when your neighbor’s house burns down.
During the financial crisis of 2008, the premiums for credit default swaps on mortgage backed securities were crazy low due to supposed low risk. And because the swaps were worth something like 5x the underlying investments, when they began to default the payouts on the defaults were massive, bankrupting the issuing investments banks and insurance companies.
To add to the other good answers, the name is also kind of confusing. What it’s saying is “Credit” (loaning someone money) “Default” (when they don’t pay that loaned money back) is being “Swapped” (trade the risk to a different company for a small payment, like an insurance policy kind of)
A CDS is a derivative product (an agreement or contract) that exchanges the risk of default on a certain set of securities. Since it’s basically an insurance policy, all of those parts are variable and part of the negotiation process between the insurer and buyer.
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