Monday, October 06, 2008

Subject to revision in the second edition 

A recent financial innovation of major importance has been the credit default swap. �The CDS, as it is called, is a derivative that transfers the credit risk, usually of a debt instrument, to a third party, at a price. �Being able to profit from the loan transaction but transfer credit risk is a boon to banks and other financial intermediaries, which, in order to make an adequate rate of return on equity, have to heavily leverage their balance sheets by accepting deposit obligations and/or incurring debt. �Most of the time, such institutions lend money and prosper. �But in periods of adversity, they typically run into bad-debt problems, which in the past had forced them to sharply curtail lending. �This in turn undermined economic activity more generally.

A market vehicle for transferring risk away from these highly leveraged loan originators can be critical for economic stability, especially in a global environment. �In response to this need, the CDS was invented and took the market by storm. �The Bank of International Settlements tabulated a worldwide notional value of more than $2o trillion equivalent in credit default swaps in mid-2006, up from $6 trillion at the end of 2004. �The buffering power of these instruments was vividly demonstrated between 1998 and 2001, when CDSs were used to spread the risk of $1 trillion in loans to rapidly expanding telecommunications networks. �Though a large proportion of these ventures defaulted in the tech bust, not a single major lending institution ran into trouble as a consequence. �The losses were ultimately borne by highly capitalized institutions -- insurers, pension funds, and the like -- that had been the major suppliers of the credit default protection. �They were able to absorb the hit. �Thus there was no repetition of the cascading defaults of an earlier era.

Alan Greenspan, The Age of Turbulence, 2007, pp. 371-72.
[T]he House Agriculture Committee, which has some oversight of commodities and futures trading, plans to hold a hearing this month on a class of derivatives known as credit default swaps. AIG held huge amounts of credit default swaps, which act as insurance against bond defaults. The prospect that AIG wouldn't be able to pay out the swaps was a major reason the government took over the company.
Houston Chronicle, Oct. 5, 2008.