Investors urged to “keep it simple”
Credit default swaps – or CDS – are complex financial products that are like a type of insurance protecting against loans not being repaid. They are traded in the financial markets but, due to their complexity, credit default swaps might not be suitable for inexperienced investors. In his seventh video lesson from the financial crisis, for example, ING Group chief economist Mark Cliffe urged investors to “keep it simple” and not invest in financial products they did not understand.
Credit default swaps are similar to insurance
A credit default swap – or CDS – insures against the possibility that a borrower defaults on a loan. A borrower could be an individual, a company or a country, while a loan could be a corporate or government bond or another type of borrowing. The issuer of the credit default swap takes on the risk of default and can make money if the loan is repaid as agreed. But if the loan is not repaid, the issuer may end up paying out and losing money on the deal. In the extreme, an issuer with many credit default swap contracts might face problems if many defaults happen at once and they struggle to pay out. Credit default swaps have been in the headlines lately due to sovereign debt worries in peripheral Europe and elsewhere.
Credit default swaps and the financial crisis
Credit default swaps played a part in the financial crisis. In the video lesson, Cliffe gave the example of mortgage backed securities that were sold and repackaged in a “giant money-go-round”. These mortgage backed securities are a type of credit default swap and demonstrate the importance, says Cliffe, of investors understanding where they are putting their money.