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Credit default swap From Wikipedia,
A credit default swap (CDS) is a credit derivative contract between two counter parties. The buyer makes periodic payments (premium leg) to the seller, and in return receives a payoff (protection or default leg) if an underlying financial instrument defaults.CDS contracts have been compared with insurance, because the buyer pays a premium and, in return, receives a sum of money if one of the specified events occur.
However, there are a number of differences between CDS and insurance, for example:
* the seller need not be a regulated entity, this, perhaps, increases counter party risk,
* in the United States CDS contracts are generally subject to mark to market accounting, introducing income statement and balance sheet volatility that would not be present in an insurance contract, and
* generally Hedge Accounting is not available under US GAAP, this also increases income statement and balance sheet volatility.
The buyer of a CDS does not need to own the underlying security or other form of credit exposure; in fact the buyer does not even have to suffer a loss from the default event. Generally, to purchase insurance the insured is expected to have an insurable interest such as owning a debt.
The Bank for International Settlements recently reported that total derivatives trades exceeded one quadrillion dollars - that's 1,000 trillion dollars -roughly about 17 times the gross domestic product of all the countries in the world combined.
Originally posted by dingleberry77
I've heard a lot about these over the last few months, but when is this bubble going to burst?
Will it be a slow trickle or a huge bang?
Here's the basic approach:
* The US Treasury would tender for all of the private label CDO/MBS extending between a range of dates, say 2004 forward to year-end 2007, representing trillions of dollars in assets held by investors and banks globally. The pricing on this paper will reflect current market prices, but say the average price was 50% of face value. Only issues that actually have an enforcable legal claim to collateral will be eligible. Derivative structures without collateral will not be eligible.
* Treasury then transfers all of the purchased toxic paper to the FDIC Deposit Insurance Fund, which acting as receiver under 12 USC restructures the trusts that are the legal issuers of the bonds and recovers legal ownership of the underlying collateral. The FDIC arguably has the power to call in all bonds and related investment contracts, and extinguish the claims of those parties which do not respond to the Treasury tender. The legal finality of an FDIC-managed receivership under 12 USC is what is required to end the toxic asset issue once and for all. The bankruptcy courts could be used in a similar fashion, but the unique legal authority of the FDIC suggests to us that this agency should run the process as part of its larger asset sale operations.
* This now "clean" whole loan collateral will then be re-sold to solvent banks in the localities where the property is located, using zip codes and other means to identify eligible buyers, priced at say 90 cents on the dollar, with a full recourse guarantee from the FDIC and financing from the Federal [...]