Prominent top US financial investor and one of the richest man in the world – Warren Buffet called the Credit Default Swaps a “Financial Weapon of Mass Destruction”. George Soros, one of the world’s leading speculators, who in 1992 made the Bank of Britain to devalue the British Pound making millions, also apprehends that the next financial crisis is in ‘Credit Default Swaps’.
America’s biggest insurance company, AIG, had to be bailed out by American taxpayers after it defaulted on $14 billion worth of credit default swaps it had made to investment banks, insurance companies and scores of other entities. The New York-based company was brought to the edge of bankruptcy in September 2008 after the value of the transactions plunged. The insurer was forced to come up with more than $10 billion in collateral to back the contracts after its debt rankings were cut. It accepted an $85 billion government loan in exchange for ceding control to the U.S.
So much of what went wrong with the financial system in the year 2008 can be traced back to credit default swaps, which has ballooned into a $62 trillion market – nearly four times the value of all stocks traded on the New York Stock Exchange.
CDS effectively is all about insurance. In this paper we compare the CDS with other types of insurance products viz., the exchange traded equity options market and the general insurance business itself to identify the glaring deficiencies of the CDS markets and the dangers that the entire financial industry is exposed to because of this colossal instrument that is presently outstanding to the extent of over $60 trillion – a no small amount by any standard.
In this paper we look into this minutely and understand why Credit Default Swaps are dangerous and what is the fundamentally wrong with this innovative financial instrument that became very popular during recent years. Needless to say that if some of the underlying flaws of this product is corrected it can be made into a ‘good’ financial derivative product thereby meeting the objectives that it sought to achieve when it was originally conceived by the market players.
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