Thursday, March 11, 2010

Credit Default Swaps

Professor Bainbridge offers a good discussion of credit default swaps at the link.

If you are confused by the whole issue:

A "covered" swap would be:

A borrows $100 from B.

B pays C an agreed amount in exchange for C's promise to pay B $100 if A defaults.

In effect, the amount B pays to C is credit insurance. If this is illegal, then what FNMA and FHLMC do should be illegal. Even credit life insurance would be questionable in that it covers one possible reason for A's default..

A "naked" swap would be:

A borrows $100 from B.

C pays D an agreed amount in exchange for D's promise to pay C $100 if A defaults.

In effect, C has placed a side bet with D.


The "agreed amounts" clearly reflect the market's perception of A's creditworthiness, but either one of these makes A more likely to default . . . how exactly?

The credit default swap market doesn't make Greece more likely to default, but it makes it painfully clear the market thinks there's a big risk of default. Attacking credit default swaps is akin to shooting the messenger.

To reply, email texthepontificator at yahoo dot com.



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