What are Credit Default Swaps (CDS) and its potential impact on the economy? According to two excellent articles in Business Week (September 25, 2008) and Time (March 17, 2008), CDS are insurance-like contracts that promise to cover losses on certain securities in the event of a default. They apply to municipal bonds, corporate debt, and mortgage securities that are usually sold by banks and hedge funds. The buyer of the credit default swap pays premiums over a period of time to the seller (typically a bank), knowing that losses will be covered if a default happens. In other words, the CDS is similar to someone taking out a home insurance policy to protect against losses.
According Harvey Miller, senior partner at Weil, Gotshal & Manges, "the CDS market has exploded to more than $58 trillion, which is almost three times the size of the U.S. stock market ($20 trillion) and far exceeds the $7 trillion mortgage market and $4 trillion U.S. Treasury market." Problem? The CDS market is not regulated. This market has no oversight to ensure that the parties involved have the financial wherewithal to cover losses if the security defaults. Solution? This market must be regulated just like other financial markets and securities.
The four most active banks in the CDS market are as follows: JP Morgan Chase, Citibank, Bank of America, and Wachovia (WB). (I would definitely keep an investment eye on Wachovia.) Indeed, according to the "Time" article, the top 25 banks hold more than $13 trillion in credit default swaps, or approximately 22% of CDS market.
The current financial focus on the mortgage debacle is well placed and deserving. However, given the size of the CDS market ($58 trillion) versus the mortgage market ($7 trillion), a potential meltdown of this market would have draconian ramifications for the economy.
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