Five Points About Credit Default Swaps That Directors Need to Know
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 Coprorate Board Member, offers five points directors need to know:
- 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.
- 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.
- 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.
- Trading CDSs needs to be disclosed. After this Nov. 15, protection sellers must disclosure their CDS exposure under new accounting rules.
- 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.