A Second Look at
Credit Default Swaps
They have been called financial weapons of mass destruction. Should they be regulated as a form of insurance?
By chris nelson
IIN BERKSHIRE HATHAWAY’S 2002 ANNUAL REPORT to shareholders, CEO Warren Buffett prophetical- ly referred to derivatives—which include credit default swaps—as time bombs and financial weapons of mass destruction. Certainly, the difficulties AIG and other companies ex- perienced honoring their commitments after selling credit default swap con- tracts contributed to bringing them, as well as the entire global financial
system, to the brink of collapse.
In the aftermath of this financial
near-Armageddon, there has been significant discussion about the need to
regulate the currently unregulated
credit default swap market. A number of federal and state regulatory
authorities and industry groups
have floated proposals, including a recent one by the National
Conference of Insurance Legislators (NCOIL) to regulate
credit default swap contracts
as insurance.
Assuming that NCOIL
(or other state regulatory authorities) is
successful in efforts to
regulate these contracts as insurance,
the implications for
the insurance industry are significant.
credit Default swaps Defined
A credit default swap is a type of swap,
which in turn is a type of derivative. Make
sense? Let’s back up. A derivative is a financial instrument that derives its value
from an underlying asset. Common types of derivatives
are forwards, futures, options, and swaps. A swap is
a financial instrument between two counterparties
in which one counterparty exchanges the cash flows
derived from one underlying asset (such as floating
interest payments on a floating rate bond) in return
for the cash flows from another party derived from
another underlying asset (such as fixed interest payments on a fixed rate bond). The most common types
of swaps are interest rate swaps (described parenthetically above) and currency swaps.
Credit default swaps are one of the simplest, but
perhaps most prevalent, types of derivative in which
credit risk is transferred between parties. Other credit
derivatives include total return swaps, credit default
options, credit spread options, and credit spread
