Read the “Global Economic Crisis” story on p. 212. Discuss the credit default sw
ID: 2750305 • Letter: R
Question
Read the “Global Economic Crisis” story on p. 212. Discuss the credit default swaps and the effects it had on the financial crisis. 75 to 150 words. The Global Economic Crisis Insuring with Credit Default Swaps: Let the Buyer Beware! A credit default swap (CDS) is like an insurance policy. The purchaser of the CDS agrees to make annual payments to a counterparty that agrees to pay if a particular bond defaults. During the 2000s, investment banks often would purchase CDS for the mortgage-backed securities (MBS) they were creating in order to make the securities more attractive to investors. But how good was this type of insurance? As it turned out, not very. For example, Lehman Brothers might have bought a CDS from AIG in order to sell a Lehman-created MBS to an investor. But when the MBS began defaulting, neither Lehman nor AIG was capable of making full restitution to the investor.
Explanation / Answer
A credit default swap is an instrument wherein the buyer of the CDS agrees to purchase the instrument from the seller on a guarantee that the seller would compensate the entire face value of the instrument, in case of a default by the debtor or any other credit event, for which it has to pay a small fee or a spread every month, and the posession of the CDS would return to the seller. The problem that happened was that the spread on these CDS's had become so huge that it was impossible for investment banks to ignore such a high earning opportunity. They began purchasing CDS of even sub standard loans which had low credit rating from the market, and converting them to MOrtgage backed security, another form of a Credit Derivative. Since the quality of these loans was poor, it kept defaulting and had an adverse impact on the financial market, as they had to compensate the buyers in case of so many defaults and this is what caused such a big financial crisis.
Related Questions
Navigate
Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.