Credit default swaps are the transfer of third party credit risk from one party to the other party.
The purchaser of the swap must make the payments until it reaches the maturity date of the assigned contract.
A better understanding of CDS is “One party in the swap is a lender and faces credit risk from a third party, and the counterparty in the credit default swap agrees to insure this risk in exchange of regular periodic payments (essentially an insurance premium).
If the third party defaults, the party providing insurance will have to purchase from the insured party the defaulted asset. In turn, the insurer pays the insured the remaining interest on the debt, as well as the principal”(Investor Words).
The worth of credit default swaps results from whether or not a company fails to pay back the amount.
The Washington Post Article “Credit default swaps are insurance products. It’s time we regulated them as such” by Barry Ritholtz on March 10, 2012 explained that it was time to change the laws regarding Credit Default swaps. The article talked about companies like Enron and AIG took advantage of the Commodity Futures Modernization Act of 2000, that promoted unregualated insurance policies.
The CFMA lead to companies wrongly swapping their defaults. The CFMA lead to the 2007-2008 Finanical Crisis that was responsible for the collapse of Lehman Brothers, CitiGroup, Bank of America, Fannie and Freddie.
The Telegraph article titled “JPMorgan losses highlight need for credit default swap regulation” goes into detail about the $17.5 billion loss JPMorgan experienced due to a series of derivate transactions in 2012. It was first believed that they only lost $2 billion during the first quarter of the year, but by the end it was calculated close to $17.5 billion. experience. The government is left in a position that they have to help them, in order to prevent another economic depression.