What on earth is CDS?

Many people are anxious whether the sub prime mortgage issue is over. Have all the banks written off their bad debts due to the sub prime mortgages. But the question is partially irrelevant because that is not the only issue facing the financial markets. Credit Default Swaps or CDS is a massive US$62 trillion dollar market.

Credit Default Swaps is like an insurance policy, used by debt owners to hedge, or insure, against a default on a debt. There is no assets or collateral involved and hence it can be speculative.Warren Buffett once described derivatives bought speculatively as "financial weapons of mass destruction." In his Berkshire Hathaway annual report to shareholders he said, "Unless derivatives contracts are collateralized or guaranteed, their ultimate value depends on the creditworthiness of the counterparties. In the meantime, though, before a contract is settled, the counterparties record profits and losses -- often huge in amount -- in their current earnings statements without so much as a penny changing hands.

The CDS market is said to be more than $45 trillion in mid-2007, according to the International Swaps and Derivatives Association and is far larger than the size of the U.S. stock market (which is valued at about $22 trillion and falling) , the $7.1 trillion mortgage market and the $4.4 trillion U.S. treasuries market according to Harvey Miller, senior partner at Weil, Gotshal & Manges. The effect of CDS's collapse would be even lower liquidity and signals the end of low interest rates. The higher interest rate would have serious impact on an already declining US economy.

CDS is an unregulated market and is used by banks to cover losses when companies fail to repay their loans. If CDS are priced low, then the bank can afford to lend relatively "risk free" at lower interest rates. Without CDS or higher priced CDS, banks would need a higher interest rate to cover the potential loss on a loan. With a slowing economy, risk to loans will increase and with problems from past CDS issued, banks may be very reluctant to lend with collaterals.

Subprime is about MBS or mortgage backed securities but how much CDS based on MBS has been issued? More curious is who are holding these MBS? In the following weeks, we may hear more about CDS and CDS may be as familiar a term as subprime. So hold on tight, the financial tsunami is on its way