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Credit Default Swaps: Ticking TIme Bomb!!!!

Warren Buffet refer Derivatives as "potential future financial weapons of mass destruction".

Credit Default Swaps are a product of financial engineering by JP Morgan Chase in 90's. They are bilateral & OTC market contracts.

Typically a credit Default Swap initiates when a initiator bank "A" lends a loan to a company. The bank "A" sells his credit risk of the loan to the second bank "B" by paying a premium amount. The second bank "B" are willing to enter these agreements because they don't have access to lend into foreign markets and use these products as indirect entry to the markets. It appears taht transactions will be hedged now.
The real problem arises when the same product is sold to multiple parties or sold continously by one party to another to form a chain. For E.g. A $1 billion loan credit default swap is sold multiple time to banks, insurance companies, hedge funds and other financial institutions. This increases the credit risk of a $1 billion loan by 4 times i.e. $4 billion towards each of the above mentioned parties.

As Derivatives is a zero sum game, someone looses and other gains yet the losses will be on a wider scale in case of default by any of the players in the chain. This was the only reason why currently failing financial institutions having a spillover effect on dozens of other companies as each one of them is linked to another thorugh these CDS. And that's why US govt. bailout Bear Stearns & AIG, understanding the impact on the markets will be for many years in case of collapse of these companies.

The big problem arises in case of defaults in US economy. Starting with, Hedge funds which have entered in those transactions does not have enough capital to support CDS agreement. They found premiums of CDS as the way of increasing their funds capital. Secondly, bank default of CDS will lead them towards bankrupcy/illiquidity thereby creating a potential threat to the public deposits their trusts & confidence on banking system.

As per International Swaps & Derivatives association, market size of credit default swap market is $62 trillion and size of US economy is $14trillion. Another important thing to know, world's GDP is only $54.6 trillion lesser then CDS market.

Now even if 10% of deafults happens, we will be seeing an impact of $6.2 trillion market commitments thereby making more companies running out of business. Majorly US & European companies which have a high degree of leverage i.e 20-30% & 40-50% respectively will not be able to serve these commitments.

Hence, one loose card can bring down whole pack of house of cards!!!!!!

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