14.24 ndian onom
It operates like an insurance policy. In an which may not otherwise be available,
insurance policy, the insurance firm pays the and increase the yield on his portfolio.
loss amount to the insured party. Similarly, the (iv) Banks can use it to transfer risk to other
buyer of the CDS—the bank or institution that risk takers, create capital for more lending.
has invested in a corporate bond issue—seeks to (v) Distribute risk widely throughout the
mitigate the losses it may suffer on account of a system and prevent concentrations of risk.
default by the bond issuer. Credit default swaps
Some analysts have serious apprehensions
allow one party to ‘buy’ protection from another
about CDS. George Akerlof, Nobel prize-winning
party for losses that might be incurred as a result
economist, in 1993, predicted that the next
of default by a specified reference instrument (a
meltdown will be caused by CDS. In 2003
bond issue in India). The ‘buyer’ of protection
investment legend Warren Buffet called them as
pays a premium to the seller, and the ‘seller’ of
‘weapons of mass destruction’. The former US
protection agrees to compensate the buyer for
losses incurred upon the occurrence of any one Federal Reserve Chairman Alan Greenspan, who
of the several specified ‘credit events’. Thus CDS betted big on CDS said after the ‘sub prime’ crisis
offers the buyer a chance to transfer the credit risk that ‘CDS are dangerous’. A leading US weekly
of financial assets to the seller without actually the Newsweek described CDS, ‘the monster that
transferring ownership of the assets themselves. ate Wall Street’. Many Indian experts had the
opinion that ‘CDS will not stabilise the economy
Let us try to understand it by an example.
rather could lead to destabilisation’.
Suppose Punjab National Bank (PNB) invests
in Rs. 150 crore bond issued by TISCO. If CDS contract are dangerous because they
PNB wishes to hedge losses that may arise from can be manipulated for mischief. It’s all about the
a default of TISCO, then PNB may buy a credit insurable interest which is never there as it is used
default swap from a financial institute, suppose, for speculation. A derivative that amounts to an
Templeton. PNB will pay fixed periodic payments insurance contract with no insurable interest is
to Templeton, in exchange for default protection bad. But do the speculators have insurable interest?
(just like premium of an insurance policy). No they don’t have any. The US ‘sub prime’
crisis was a fallout of such CDS contracts—one
CDS can be used for different purposes in a
defaulting and another claiming the ‘protection’
financial system, viz.,
finally resulting into the defaulter of the insuring
(i) Protection buyers can use it to hedge company—overnight the biggest US insurance
their credit exposure while protection giant, AIG went bankrupt. So happened with
sellers can use it to participate in credit
many US banks also.
markets, without actually owning assets.
The most damaging aspect of CDS is that the
(ii) The protection buyer can transfer credit
credit risk of one country/region gets exported to
risk on an entity without transferring
another country/region very smoothly and silently.
the under lying instrument, reap regular
Thus There is a serious chance of ‘contagion effect’
benefit in terms of lower capital charge,
suppose there are defaulters there, the thing which
seek reduction of specific concentrations
happened during the US ‘sub prime’ crisis.
in credit portfolio and go short on credit
risk.
SecuritiSation
(iii) The protection seller will be able to
diversify his portfolio, create exposure to This is the process of issuing ‘marketable securities’
a particular credit, have access to an asset backed by a pool of existing assets such as auto