Securities Fraud Lawyers

Credit Default Swaps

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A credit default swap (CDS) is a type of derivative that consists of an insurance-like contract that promises to cover losses on certain securities in the event of a default. The buyer of the CDS makes a series of payments (premiums) to the seller and, in exchange, receives a payoff if a credit instrument goes into default, or in the instance of a specified credit event, such as a bankruptcy or restructuring.

Many types of securities can be subject to a CDS, including municipal bonds, corporate debt and mortgage securities. The first swaps were launched in the 1990s, and were seen as relatively "easy money". That's because the economy was booming and corporate defaults were few back then. At that time, swaps were a low-risk way to collect premiums and earn extra cash.

Commercial banks, in particular, were especially drawn to the CDS market. By the third quarter of 2007, the top 25 banks held more than $13 trillion in swaps, as both buyer and seller. JP Morgan Chase, Citibank, Bank of America and Wachovia were ranked among the top four most active.

Swaps are used for a variety of reasons. For one thing, swaps allow investors to speculate on changes in an entity's credit quality, since generally CDS spreads will increase as credit-worthiness declines, and decline as credit-worthiness increases. Therefore an investor might buy CDS protection on a company in order to speculate that a company is about to default. Alternatively, an investor might sell protection if they think that a company is not going to default.

A CDS is often used to manage the credit risk which arises from holding debt. Typically, the holder of, for example, a corporate bond may hedge their exposure by entering into a CDS contract as the buyer of protection. If the bond goes into default, the proceeds from the CDS contract will cancel out the losses on the underlying bond.

While a CDS may appear to be a type of insurance, there is one big difference between a swap and traditional insurance. Unlike insurance companies and banks, the CDS market is not subject to any regulation. These derivatives can be swapped from investor to investor without anyone overseeing the trades to ensure the buyer has the resources to cover the losses if the security defaults. This makes it very hard for banks to value the swaps on their books.

Swaps hold many risks, especially in a bad economy. For instance, a bank may not have the assets on hand to pay the investor in the event of a default.The investor may be betting that there will default and use the transaction to make a profit. Finally, the credit-default swaps on the debt in the market may exceed the value of the bonds many times over. In 2008, volatility in the CDS market led American International Group Inc. (AIG) to report the largest loss in its history, due to an $11-billion write-down of its CDS holdings. This prompted the federal government to prop AIG up with an $85 billion loan. The unregulated CDS market also played a major role in the abrupt demise of Bear Stearns and the dramatic bankruptcy of Lehman Brothers.

In September 2008, the New York Attorney General and the U.S. Attorney's Office in Manhattan announced a joint investigation into the CDS market. State Attorney General Andrew Cuomo and Michael Garcia, the U.S. attorney in Manhattan, said their offices would work together to investigate whether the multitrillion-dollar CDS market was illegally manipulated.

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