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
         (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