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Rehabilitating CDS (Credit Default Swaps)

http://www.economist.com/opinion/displaystory.cfm?story_id=12562363

Derivatives

Giving credit where it is due

Nov 6th 2008
From The Economist print edition

The credit-default swap needs reform, not abolition

FINANCIAL innovations tend to go through four phases. At first, they are hailed as proof of the brilliance of the bankers who devised them. Then they succumb to rampant speculation, as investors try to exploit them. And that leads to revulsion, as a crisis causes widespread losses. The question is: should the fourth phase be rejection or rehabilitation?

The latest innovation to pass through the cycle is the credit-default swap or CDS. Despite its forbidding name, the CDS is a simple idea: it allows an investor to buy insurance against a company defaulting on its debt payments. When it was invented, the CDS was a useful concept because more people felt comfortable owning corporate debt if they could eliminate the risk of the issuer failing. The extra appetite for debt helped lower the cost of capital.