Five Things Everyone Should Know About Credit Default Swaps

(MoneyWatch)  Ever since the financial meltdown began in earnest in August, corporate directors have been hit with a series of complex new problems -- not to mention a complex new vocabulary -- to deal with.

One of them has to do with Credit Default Swaps which are complicated, derivative-based hedges that theoretically help guarantee risk. Yet, these over-the-counter instruments have been blamed for enflaming the financial mess and could represent as much as $50 plus trillion in distressed assets.

The law firm of Paul, Weiss, Rifkind, Wharton & Garrison, in an article in Corporate Board Member, offers five points directors need to know:

1. CDSs are credit risk transfer vehicles. A protection buyer agrees to make a payments or payments in exchange for a protection seller to pay a certain amount if certain events occur. These can be highly-tailored to fit needs and in "naked" CDSs, the buyer has little or no exposure.
2. CDSs are used increasingly to assess credit worthiness. CDS spreads signal a market's expectations of a credit event occurring. Hence, loan pricing is affected.
3. CDS are a growing part of the derivatives markets. They exploded on the scene a few years ago and now represent about $54.6 trillion.
4. Trading CDSs needs to be disclosed. After this Nov. 15, protection sellers must disclosure their CDS exposure under new accounting rules.
5. CDSs are the subject of intense regulatory scrutiny. The SEC, the New York State Department of Insurance and other regulators are looking into possible fraud.

This post first appeared in the BNET Insight blog The Corner Office.