November 23, 2009

Credit Default Swaps - Anti-Social?

As we all know, derivatives and CDS in particular were the focus and a root cause of the failures of big banks in the recent 1 year.Investors like Warren Buffet had warned years before about the ill-effects of using derivative instruments. They described them as "dormant economic weapons of mass destruction" of size upto $500 Trillion dollars . But people simply ignored the wise words...they simply loved the idea of leverage to make BIG money....

A recent article in the Financial Times, refers to CDS as an anti-social product. Its very interesting to know why. As many of you might know, a CDS involves 3 parties. One which has granted credit to another party (e.g. Corporation A gives credit to Corporation B) and the third which insures that loan (e.g. AIG). If company B fails to pay-back or has a credit downgrade, AIG would compensate company A. In return for this protection, Company A pays AIG a regular premium (insurance premium).

Thus CDS is anti-social as there is an incentive for Company A debt holders that Company B fails. There are also real cases wherein the debt holders of Company A forced Company B to go bankrupt. But what if the intermediary who provides for the protection (AIG in this case) also fails? This is what exactly happened ! Company A was left to the street along-with Company B and all the intermediary insurance providers.....The Financial world was paralysed and is still recovering......

3 comments:

Sangeeta R. Goswami said...

Hiii,
Me and some of my frnds hv started an E-magazine called Readers's Quotient, it is totally for a noble cause, u can contribute to fund children education through ur writer ups, shan't u be willing to come along with us ?

If yes pls contact us on sangeeta.goswami@readersquotient.com

waiting for ur revert

regds Sangeeta
www.readersquotient.com

ambarish said...

WOnderful and highly informative blog..!

Keep up the good work..!!

Regards
Ambarish Kulkarni

Makarand Prabhune said...

Thank You !