WIll Credit Default Swaps Trigger The Next Financial Crisis?
What is a credit default swap? Invented in 1995 by Blythe Masters of J. P. Morgan, credit default swaps have become the most widely traded kind of credit derivatives in the market place. They are financial instruments whose price and value derive from the creditworthiness of the obligations of third parties. A credit default swap is a bilateral contract: The ‘buyer’ of the CDS wants to be protected if a third-party debtor doesn’t make payments when they become due. The ‘buyers’ enters into an agreement with ‘the seller’. They agree to make regular fee payments to the seller in exchange for “insurance” against the possibility of default by a third party. If the third party doesn’t pay, the seller takes the bond or other credit instrument and pays the buyer the par value of the bond (called a “physical settlement”) or simply pays the buyer the difference between the par value and the recovery value (a “cash settlement”). The market for credit default swaps is completely unregulated, and
