The Credit Default Swap...A Contributing Factor to Today's Economy

There is not really one clear reason as to why the economy is in the situation that it is in today. There are many contributing factors that have been at the center of the government's investigation consisting of subprime mortgages, high consumer default rates as well as unemployment. However, one of the known, but not talked about, contributors to the current state of our economy is an investment product called a Credit Default Swap.

Below is a short explanation of the credit default swap as shown from wikipedia:

A credit default swap (CDS) is a credit derivative contract between two counterparties, whereby the "buyer" or "fixed rate payer" pays periodic payments to the "seller" or "floating rate payer" in exchange for the right to a payoff if there is a default^[1] or "credit event" in respect of a third party or "reference entity". (Source)

To put this in more plain terms, take the following example:

Most of us (the buyer) who have cars have car insurance in the case that something happens to our car and we need to have our car replaced. We pay a periodic "premium" to an insurance company (the seller) in return to have the insurance company to provide the replacement cost of our car in the event that something happens to it. In most cases, if something happens to our car, we have to provide evidence to the insurance company by showing them the car. After the insurance company sees the car, they will more than likely provide you the money according to the previous agreement. Sounds reasonable right...

Well, let's take a look at Credit Default Swaps. The way it was designed to work is to allow investors to buy insurance on fixed income that they bought from a company (such as a company bond) so in the case that the company went bankrupt, they could recover some of the cost they invested in the bonds. Well, due to many factors, this started to be abused by investors and instead of actually buying the insurance to protect against losses for bonds possessed by the investor, they began buying the insurance with intent of receiving a big payout if the company went bankrupt.

Since there is technically no regulation in this market, investors did not need to show proof that they owned $10 million dollars worth of bonds to take out $10 million dollars of protection against this bond. In addition to that, the companies providing the protection (insurance companies and others) would gladly accept the insurance premium paid by the investor to insure companies (such as Lehman Brothers and Washington Mutual) that seemed financially sound and did not look to have a big risk of defaulting over the past years.

In most cases, those same insurance companies did not set aside the needed capital to cover the coverage promised in the case of a default by those companies (although they signed contracts legally obligating them to pay the specified coverage). So in turn, when major corporations, who have been opened for multiple decades (such as Lehman Brothers and Bear Stearns), began to fail, those insurance companies were unable to pay contributing to the bankruptcy problem being experienced by our financial institutes.

The insurance companies never should have accepted premiums from investors that could not prove if they owned the fixed income securities. In addition to that, they should have operated as their purpose and set aside the money necessary to cover the insurance claims in case of a default.

The financial lesson learned is that unethical business practices (AKA greed) never pays off and is eventually destined to fail. A lesson that we all can learn from this is that there are not too many highly-probable ways to get rich quickly. It all comes down to how much risk you are willing to take as well as the level of loss that you are able to deal with. Below are some of the lessons that I have learned recently about greed and personal finance in regards to my situation:

1. Day-Trading in the Stock Market
2. Investing in Penny Stocks
3. Investing without doing Due Diligence on companies

By no means am I trying to discount these methods of investing as many will argue that these exact methods have worked for them. I am purely providing my experience with these methods in hope to save someone the financial grief that I have experienced before. By all means, if you have the magic formula that works for you 99.99% of the time, please feel free to share it with us.

P.S. - I learned about the Credit Default Swap product from attending a highly informative ToigoTalk about the subject. Click on the link to learn more about this and other financial topics.

For another interesting article about Credit Default Swaps, check out the following link:

http://www.dailywealth.com/archive/2008/oct/2008_oct_04.asp