However, under circumstances where there is rising connectivity between institutions because of the dense nature of the webs of CDS, attempts to share risk increase the likelihood that a bank will go under. International banks making loans to banks or corporations are in order to protect themselves from systematic economic turmoil by buying swaps on sovereign debt but there are limits to this because what reduces risks for individual institutions in small quantities spells doom for larger institutions when pushed too far. This can be detrimental considering that the number of CDS contracts outstanding on European sovereign debt doubled in the past three years after the AIG setback. Actions have unanticipated consequences
. The financial deregulation in 2000 led to the mushrooming of unregulated and largely hidden CDS contracts. This had made the financial marker riskier than ever. With the deregulation of the CDS market a bank can sell as many CDS as it wishes and invest the money whenever it wants. When the bonds started going bad in 2008, CDS were introduced for traditional corporate debt, mortgage backed securities, CDOs, and secondary CDOs. When optimism fell, the CDS for exotic products shot up. The CDS was a way in which losses on subprime mortgages triggered write-downs at other financial institutions. When banks like Lehman and Bear Stearns started failing the situation became dire as people who had sold these swaps were looking at losses on them. Insurers and a host of companies that were selling CDS sold them at extremely low prices that made them incur major losses. The companies that were selling the CDS many of which were not insurance companies had the risk that the insurance companies were not able to pay. Had AIG, for instance, sold a lot of CDS based on debt it owes say Lehman, it couldn't have honored all the swap contracts. Their counterparties had to incur losses they were insured against. If bank X bought a CDS from bank Y on the company Z, and the company Z. defaults, bank X thinks it has payment coming to it from bank Y; but if bank Y doesn't have the cash, bank X cannot get its payment. This example helps explain how CDS create uncertainty in the banking sector. Banks may appear healthy but are in essence counting on CDS payouts from other banks that cannot be seen. The CDS spreads risks in unpredictable and invisible ways. Perhaps the United States government refusal to let AIG fail after Lehman had failed best explains this. The AIG was a large net seller of CDS. Had it defaulted on these swaps the implications could have had far reaching ramifications for the financial sector
. Its failure could have amplified and spread the uncertainty as to reduce confidence in the financial sector.
Uncertainties in the unregulated credit default swap markets are also caused by the fact that investors who have purchased these swaps normally have trouble tracking down those who are supposed to pay their claims
. Contracts are sold and resold among financial institutions. Original buyers cannot therefore know that a new, potentially weaker entity has taken over the obligation to pay the claim. This makes potential buyers of such swaps and investors to be wary of such markets because of fear of losing their monies.
Credit default swaps and government debts
The International Monetary Fund avers that credit default swaps are an effective tool that investors use to check against hedging. Investors also use them to express an opinion about the credit worthiness of a government
. It helps the investors to cushion themselves against losses attributed to debt restructuring by the borrowing governments. However, speculative use of sovereign credit default swaps in advanced economies has been associated with destabilizing effects on the financial system. This has occasioned the European Union to burn the purchase of protection using CDS contracts if the buyer is not hedging.
Fig 1. Five-Year credit default swap spreads within the United States
Adopted from the Economist
Sovereign credit default swaps at not effective at representing the credit risk of governments because credit default swaps on government debts are just but a fraction of a country's outstanding debt market. The IMF
finds little evidence to support the negative publicity that credit default swap has received relating to its destabilizing ability. In fact, it decries the EU's ban on naked selling of credit default swaps, averring that such action can potentially harm the hedging role of the markets as market liquidity and depth deteriorate. This can potentially spill to other markets. The hedgers can subsequently migrate their hedges to the next best markets. This can stress and make the markets more volatile. This can in long-term lead to increase in sovereign funding costs. It is also not very clear whether credit default swap markets are...
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