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Created with Fabric.js 1.4.5 CDS was initially created in the late 1990s. What is CDS? HistoryWhat is CDS? History/What is CDS? It is a form of "insurance". How it works CDS' buyers pay an amount of moneyperiodically to transfer the risk of defaulton their securities to the sellers. In returnfor periodic payments from buyers of CDS,issuers will pay the buyers' loss on theirsecurities (bond) position. Economic Collapse-Credit Crisis (2007-2008) Lack of regulations.No transparency.High credit ratings.Low collateral.Naked CDS. Credit Default Swaps (CDS) & Credit Crisis 2003-2006: economy was going well, housing boom, credit rating agencies(CRAs) rated mortgage-backed securities(MBS) really high, even when they containedsubprime mortgage. Sellers of CDS mistakenly assumedMBS contained low risk of default. Many financial institutions accumulated largeholdings of MBS during the housing boom in 2003-2005.In 2006, financial institutions started to buy CDS contracts to be protected against default of these MBS due to the forecast of decline in housing prices. Buyers purchase CDS contracts from issuers such as banks, insurance companies, and hedge funds to protect their investments against default of municipal bonds, corporatebonds, and mortgage-backed securities. Many MBS defaulted during the credit crisis. AIG was the major seller of CDS. It had $440 billion in CDS contracts, with most of the underlying assets being subprime MBS. Purpose: protect against defaults on extremely safeinvestments like municipal bonds (loans madeto cities to finance projects. Periodic premium payments made CDS asteady source of extra cash flow for the issuers. This type of derivatives became a popular amongthe huge issuing banks and the investors. AIG did not hold enough reserves to cover its obligations of $32.8 billion in 2008, which caused it to go bankrupt. A systematic risk occurred: If AIG couldn't cover all its obligations for the financial institutions that bought CDS from it, they would all go bankrupt one by one. This will bring down the U.S. economy. The Fed had to bail out AIG with $85 billion. Future Proposal + Stricter regulations over CDS contracts. + Create one or more regulated clearing house: - brings more transparency - reduce risk for parties of CDS at any risk is borneby the exchange. + Increase regulatory control over CRAs. + Sellers of CDS contracts must have collateral of between 5-18% of the contracts value the percentage will dependent on its rating.
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