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Can you explain the credit-swap insurance dangers?

lovedaywaymouth
by lovedaywaymouth 22 October 2008  |  Comments 2 comments  |  Love Love  0 loves

I understand that the banks insured against default on their lending and a market has developed in those insurance policies. This sound like a huge probelm to come and a reason for staying out of the stock market. Or have I misunderstood?

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Comments (2)

  • complyman
    Love rating 0
    complyman posted

    This is a key reason why the US goernment ploughed money into AIG which was heavily exposed. If AIG had gone down it would have taken a lot of the banks with it. The trouble with a lot of these swops is that it happened in an unregulated market where some of the participants did not even have the money to back their guarantees. The collapse of Lehmans had far reaching consequences which led to the collapse in share price of banks like HBOS. Hopefully the rescue packages will work but it will take a while to resolve.

    Posted on 22 October 2008 | Love Love  0 loves Report
  • ThatLindseyGuy
    Love rating 114
    ThatLindseyGuy posted

    You're right - this problem has been flagged in the financial community for a while.

    Essentially, credit default swaps (CDSs) are insurance policies against companies going bust.

    While the financial system was awash with cheap money and companies were not going bankrupt, financial institutions sold these CDSs and pocketed the money as they were never required to pay out claims.

    Now that cheap credit is a thing of the past, bankruptcy becomes a lot more likely for companies with weak balance sheets, good examples being Ford and GM.

    Should either of these go bust, certain financial institutions will have to pay billions of dollars in claims to CDS holders.

    The problem is that the financial institutions don't have billions of dollars of cash to pay out, so they would also go bankrupt.

    And then any companies dependent on those institutions for credit will face difficulty when refinancing, and a good number of those companies will also fail.

    The term 'vicious circle' comes to mind!

    Posted on 22 October 2008 | Love Love  0 loves Report

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