Credit Default Swaps and the Sub Prime Lending Crisis

Credit default swaps are the instruments that were responsible initially for the sub prime lending fiasco and they led to the economic crisis in America which eventually turned into a global crisis. A credit default swap is a form of insurance policy, which is not regulated by the insurance industry because they were named swaps instead of insurance policies, which helps a financial institution protect itself in the event a credit instrument fails or defaults.

The problem right in the beginning was due in part to the fact that no type of entity was regulating these particular credit instruments. If there had been regulation in place then someone would have known that these types of transactions were a crisis waiting to happen and they could have interjected and taken the necessary actions to stop any future transactions from taking place.

A credit default swap works in much the same way as an insurance policy. It protects the holder of a credit or financial instrument or asset in the event there is a default. Lets’ say for example the JETT company owns a financial instrument or credit instrument and they want to cover themselves because they are worried that the individual paying on the loan may default. They will contact the LAGG Company in order to set up a transaction that enables them to purchase a Credit Default Swap which basically is insuring the JETT Company from a loss in the event of a default. Now once again this is primarily the same way an insurance policy works.

So if a loss were to occur the Jett Company would be covered for the amount of the loss. The entire time the JETT Company is making small minimum payments to the LAGG Company to keep the insurance coverage in place, just like insurance premiums keep an insurance policy in place.

The problem lies in the fact that when the default eventually took place the LAGG company did not keep any money on hand to cover the losses and the problem steam rolled from there into the global crisis we are experiencing right now. Had these types of transactions been regulated then the governing body would have made sure that the LAGG Company had sufficient reserves on hand to cover the losses. If the reserve requirement ever dipped below the required amount the regulating body would have stepped in to make right the process.

There has been a lot of speculation as to whether or not the Credit Default Swaps were responsible for the credit crisis, but no one is disputing the fact that they played a major role even if they were not primarily responsible.

The credit asset or loan being insured in actuality was the subprime loans which are loans which fall outside of the normal credit extension criteria for one reason or other. These were loans made to individuals that had less than perfect credit or maybe the income was not sufficient, in which case they were taking on a loan which they could not afford. Borrowers of this type were a lot riskier than your standard customer so this episode we are experiencing right now was bound to happen sooner or later.

The sub prime loans were also equipped with ARM loans, (Adjustable Rate Mortgages), and when the indexes, which govern the rate, were reset we saw customers rates on their ARMs increase which ultimately led to an increase in their payments which they could not pay and it led to an avalanche of foreclosures. There is several money lenders are here in the market but you need to find the licensed money lender as they have to charge a least amount of interest over the allotted money. So the individual will be at ease while paying off the while amount.

What do you think?

Stefan Smith

Written by Stefan Smith

Stefan Smith is currently the managing editor of Nfl Touch Down. She is the author of ‘Sweet Life’ and the recipient of Pen and Scroll award.

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